Leverage in forex reviewed in South Africa. Leverage is the ability to control a substantial amount of money in the forex market with only a relatively small deposit, your margin, in your trading account. With leverage forex traders have more trading opportunities in the market than what they are required to pay for. Thus, the main advantage of leverage in forex is that a trader can make reasonable to significant profits with only a limited amount of capital.
Leverage in the world of finance
A variety of descriptions are used to describe leverage in financing, also referred to as financial leverage or trading on equity.
Descriptions are, inter alia:
- “Financial leverage … refers to the use of debt to acquire additional assets.” (AccountingCoach)
- “Leverage is an investment strategy of using borrowed money – specifically, the use of various financial instruments or borrowed capital – to increase the potential return of an investment. Leverage can also refer to the amount of debt a firm uses to finance assets.” (Investopedia)
- “Financial leverage is the use of borrowed money (debt) to finance the purchase of assets with the expectation that the income or capital gain from the new asset will exceed the cost of borrowing.” (Corporate Finance Institute)
Leverage ratio and margin requirement
Leverage ratio
Usually, the amount of leverage provided by forex brokers is expressed as a ratio. For example 50:1, 100:1 or 200:1, depending on the rules, conditions, and regulations of the broker and the size of the position that the investor is trading.
Examples of leverage ratios available for forex traders:
- 50:1: Fifty-to-one leverage indicates that for every $1 you have in your trading account, you can trade up to $50. For instance, if you deposited $1 000, you would be able to trade up to an amount of $50 000 on the forex market.
- 100:1: One-hundred-to-one leverage stipulates that for every one dollar you have available in your trading account, you can place a transaction worth up to $100. A minimum deposit of $1 500 would give you the opportunity to trade with $150 000.
This is the most popular ratio in forex leverage.
Leverage put into practice.
You had invested $2 000 in the EUR/USD currency pair and the currency rate moves up 200 pips from 1.1210 to 1.1410. Your profit would have been $10.
However, by using a leverage of 100:1, every $1 you invest is worth $100. With your $1 000 margins you can open a $100 000 trade. The result is a $1 000 profit instead of a $10 profit.
(The unit of measurement to express the change in value between two currencies is called a “pip.” (Babypips))
Margin requirement
While leverage is expressed as a ratio, the margin is indicated in percent of the full amount of the position. However, they basically show one and the same thing.
For example A 50:1 leverage ratio implies a 2% margin requirement for a trader, meaning that the trader is required to have at least 1/50 = 2% of the total value of trade available as cash in the trading account. A 0.5% margin indicates that you are using a leverage of 200:1 (1/0.005 = 200).
If your leverage ratio is 100:1, and you want to open a 50 000 EUR/USD position, €500 (€50 000 x 0.01) will be blocked from your trading account so that you can use your leverage position.
Margin is described in different ways: Free margin stands for the amount that is not currently used for trading and is the difference between the trading account equity and the used margin, the margin that is locked up that can not be used to open new positions.
Words of caution: If the general terms and conditions of a forex broker permit it, margins and leverage are subject to change at any moment, sometimes even without prior notice. This could directly affect your account. For instance, your broker decides to increase the margin of your 50 000 EUR/USD position from 1% to 5%, in other words, to decrease it from 100:1 to 20:1. The result is that you will be required to provide €2 500 for margin instead of €500 to keep your EUR/USD 50 000 positions open. In case you do not have enough funds to cover the requirement, your position will be automatically liquidated.
The management of leverage risk
Forex leverage can equally be useful or ruinous to your forex trading. Although a helpful tool, it is also a process with risks. Proper risk management minimizes losses.
Some tips to manage risk pertaining to leverage in forex:
- Try to avoid any highly leveraged forex trading when you get started and before you are more proficient at forex trading.
- Less is more. In general, the less leverage you use, the better.
- Although it is available, you do not have to use it.
- Limit the amount of capital for each position.
- Experienced forex traders usually include the use of stop orders and limit orders in their trading strategy.
With a limit order, a trader sets the minimum or maximum price at which he/she would like to buy or sell, while a stop order specifies the particular price at which a trader would like to buy or sell.
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