What is Leverage on Forex?
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What is leverage?
To trade with leverage, one must understand what it is and what we need it for. Leverage is a ratio of borrowed money to your own funds. It is also called trading leverage or financial leverage. To better understand what leverage is, study an example below.
You’ve got 10,000 USD that you want to invest and multiply. Let’s assume that you have an opportunity to buy a smartphone for 100 USD, take it to some other town, and sell it there for 101 USD. 10,000 USD is enough to buy 100 smartphones, and by selling them for 101 USD each, you’ll get 100 USD profit. The entire procedure may take, let’s say, 5 days.
As a result, your profit over 5 days will be 100 USD excluding related expenses. To increase possible profit for the same period of time, you may go to a bank and ask for a loan of another 10,000 USD. In such a way, you’ll have 10,000 USD of your own money and 10,000 USD borrowed from a bank; as a matter of fact, you will work with double leverage, which is 1:2. So, you do the same, but this time the number of smartphones you buy is 200. By selling them for 101 USD, you’ll get 200 USD profit over 5 days.
The investment period is the same, but your profit increased, even considering related expenses. Then you go to a bank and ask for another loan of 100,000 USD more, so that you could increase your profit up to 2,000 USD over the same 5 days. In this case, your leverage is 1:10, while a loan of 1 million USD will increase it up to 1:100.
What are possible risks one may incur with high leverage?
When you borrow money from a bank, your initial funds of 10,000 USD serve as a security, and the money you loan can be used only to buy smartphones, which will also be considered as a security asset for a bank. Let’s study an example with a leverage 1:100. You have 1 million USD and can buy 10,000 smartphones. If the market price adds 50 cents, you profit will be 5,000 USD, but if it loses the same 50 cents, your loss, unaccounted so far, will be 5,000 USD.
Of course, you don’t have to sell smartphones at the worse price and can wait until they cost 100 USD again, but the problem is that if the price goes down to 99 USD, you will risk not only your own money, but the bank’s money as well. As they say, “If you owe the bank 100 USD, it’s your problem, but if you owe the bank 1 million USD, it’s a problem of the bank”, that’s why in order to avoid such situations, the bank will sell your smartphones at your loss and take the security in order to reimburse the loan with minimum losses for itself.
As a result, one may conclude that the bigger your leverage value in transactions, the higher the risks involved. Probably, we might stop our explanation right here, but it’s really only the beginning.
Why traders use leverage on the Forex market?
First reason
The first reason why traders use leverage is that most beginners have small initial deposits. In most cases, opening a position of 0.01 lots require you to have about 1,000 USD on your account. In case your deposit is 100 USD, you can set your leverage value at 1:10, but you will be able to open only one position of the minimum volume and only in one currency pair. At the same time, risks to lose your deposit will be rather low. However, markets offer a lot of different currency pairs, that’s why if you use your trading system for several assets, you’d better ignore other signals and wait until your open position is completed. It will decrease risks, but your profitability will drop as well. In other words, under such circumstances you won’t be able to earn more.
With leverage 1:100, you have an opportunity (once again, pay attention to the word “opportunity”) to open positions in other currency pairs if you think that they are highly potential to yield profit. This opportunity may also be used for hedging an already open position via other currency pairs. In such situations, leverage is not only the way to diversify risks, but also to increase return from invested funds.
Second reason
The second reason lies in low profitability of the currency market. What does it mean? For example, let’s consider EUR/USD. Over the last month, the biggest difference between the highest and lowest prices was 1.5%. In other words, if you, by any miracle, managed to open a short position at the highest price and close it at the lowest one, your profit would be 1.5%. As a result, excluding leverage, you could increase your deposit only by 1.5%. But this example describes perfect conditions.
On the real market, even return of 1.0% would be a great result. When trading like this, your annual return may be 12% and that’s a good outcome if your deposit is 50,000 USD. However, you should remember that you will have both profitable and non-profitable positions and your profitability may both double and go down by a half. That’s why without using leverage, the annual profitability of your trading account may be less than you may receive from a bank deposit, which is less risky.
So, using leverage (for instance, 1:100), you have an opportunity to increase your deposit profitability. For this, you will need a strategy to stick to while trading. As a comparison: Tesla stocks added 35% over a month, that’s why you don’t have to use leverage on the stock market. Due to high volatility in stocks, using leverage is associated with high risks. Association of leverage with high risks first appeared on the stock market and then moved to Forex, but the Forex market volatility is dozens of times less, that’s why Forex may compete with the stock market in profitability only if traders use leverage.
Third reason
The third reason to use leverage when trading is an opportunity to use borrowed funds only if necessary. For example, you buy a new car and decide on its configuration. The car has an automatic gearbox, but not “Kickdown” acceleration button (automatic gearboxes kick down to a lower gear to make use of the greater power delivered at the engine’s higher rpm). You have an opportunity to add this feature for free, but you don’t have to do this. In other words, you have a choice. You may never need this feature, but someday it may save your life on the road if travel conditions are difficult and unpredictable. Adding “Kickdown” acceleration button gives you a chance to use it when it is really necessary.
Fortunately, trading on the Forex market won’t claim your life, but situations may be very different. During the crisis of 2008, the USD was strengthening against all other currencies and usage of leverage at that time might have helped raise profitability. Another case was the Brexit referendum results, which made GBP/USD plummet by 12%. Again, leverage might have allowed to make profit off of this price movement. Consequently, in some cases leverage is useful and advantageous for increasing profitability of your deposit.
Who should use leverage? Which one?
If you are a beginner on the Forex market and have no experience, you shouldn’t use leverage more than 1:10. However, when opening a trading account, choose the account type where leverage may be increased up to 1:100, so that you could use it at the right time.
If you are a very emotional trader and make decisions based on your intuition, you are recommended to choose leverage 1:5. This leverage value will prevent you from losing your deposit early in your trading career and help you gain experience to create your own trading strategy. After your trading results become more or less stable, you may increase leverage.
Conclusion
Leverage provides traders with an opportunity to use their money for trading on the Forex market more efficiently. However, lack of understanding how to use it may have a disastrous impact. That’s why before starting to trade, read the article How to Trade with Leverage, learn how to calculate the optimum size for each order, and only after that pursue a successful career on the Forex market.
