Forex Leverage: A Double-Edged Sword (2024)

One of the reasons so many people are attracted to trading forex compared to other financial instruments is that with forex, you can usually get much higher leverage than you would with stocks. While many traders have heard of the word "leverage," few know its definition, how leverage works, and how it can directly impact their bottom line.

The concept of using other people's money to enter a transaction can also be applied to the forex markets. In this article, we'll explore the benefits of using borrowed capital for trading and examine why employing leverage in your forex trading strategy can be a double-edged sword.

Leverage involves borrowing a certain amount of the money needed to invest in something. In the case of forex, money is usually borrowed from a broker. Forex trading does offer high leverage in the sense that for an initial margin requirement, a trader can build up—and control—a huge amount of money.

To calculate margin-based leverage, divide the total transaction value by the amount of margin you are required to put up:

For example, if you are required to deposit 1% of the total transaction value as margin and you intend to trade one standard lot of USD/CHF, which is equivalent to US$100,000, the margin required would be US$1,000. Thus, your margin-based leverage will be 100:1 (100,000/1,000). For a margin requirement of just 0.25%, the margin-based leverage will be 400:1, using the same formula.

Margin-Based Leverage Expressed as RatioMargin Required of Total Transaction Value
400:10.25%
200:10.50%
100:11.00%
50:12.00%

However, margin-based leverage does not necessarily affect risk, and whether a trader is required to put up 1% or 2% of the transaction value as margin may not influence their profits or losses. This is because the investor can always attribute more than the required margin for any position. This indicates that real leverage, not margin-based leverage, is the stronger indicator of profit and loss.

To calculate the real leverage you are currently using, simply divide the total face value of your open positions by your trading capital:

Real Leverage = Total Value of Transaction / Total Trading Capital

For example, if you have $10,000 in your account, and you open a $100,000 position (which is equivalent to one standard lot), you will be trading with 10 times leverage on your account (100,000/10,000). If you trade two standard lots, which are worth $200,000 in face value with $10,000 in your account, then your leverage on the account is 20 times (200,000/10,000).

This also means that the margin-based leverage is equal to the maximum real leverage a trader can use. Since most traders do not use their entire accounts as margin for each of their trades, their real leverage tends to differ from their margin-based leverage.

Generally, a trader should not use all of their available margins. A trader should only use leverage when the advantage is clearly on their side.

Once the amount of risk in terms of the number of pips is known, it is possible to determine the potential loss of capital. As a general rule, this loss should never be more than 3% of trading capital. If a position is leveraged to the point that the potential loss could be, say, 30% of trading capital, then the leverage should be reduced by this measure. Traders will have their own level of experience and risk parameters and may choose to deviate from the general guideline of 3%.

Traders may also calculate the level of margin that they should use. Suppose that you have $10,000 in your trading account and you decide to trade 10 mini USD/JPY lots. Each move of one pip in a mini account is worth approximately $1, but when trading 10 minis, each pip move is worth approximately $10. If you are trading 100 minis, then each pip move is worth about $100.

Thus, a stop-loss of 30 pips could represent a potential loss of $30 for a single mini lot, $300 for 10 mini lots, and $3,000 for 100 mini lots. Therefore, with a $10,000 account and a 3% maximum risk per trade, you should leverage only up to 30 mini lots even though you may have the ability to trade more.

Leverage in Forex Trading

In the foreign exchange markets, leverage is commonly as high as 100:1. This means that for every $1,000 in your account, you can trade up to $100,000 in value. Many traders believe the reason that forex market makers offer such high leverage is that leverage is a function of risk. They know that if the account is properly managed, the risk will also be very manageable, or else they would not offer the leverage. Also, because the spot cash forex markets are so large and liquid, the ability to enter and exit a trade at the desired level is much easier than in other less liquid markets.

In trading, we monitor the currency movements in pips, which is the smallest change in currency price and depends on the currency pair. These movements are really just fractions of a cent. For example, when a currency pair like the GBP/USD moves 100 pips from 1.9500 to 1.9600—that is, just a 1 cent move of the exchange rate.

This is why currency transactions must be carried out in sizable amounts, allowing these minute price movements to be translated into larger profits when magnified through the use of leverage. When you deal with an amount such as $100,000, small changes in the price of the currency can result in significant profits or losses.

Risk of Excessive Real Leverage in Forex Trading

This is where the double-edged sword comes in, as real leverage has the potential to enlarge your profits or losses by the same magnitude. The greater the amount of leverage on the capital you apply, the higher the risk that you will assume. Note that this risk is not necessarily related to margin-based leverage although it can influence if a trader is not careful.

Let's illustrate this point with an example. Both Trader A and Trader B have a trading capital of US$10,000, and they trade with a broker that requires a 1% margin deposit. After doing some analysis, both of them agree that USD/JPY is hitting a top and should fall in value. Therefore, both of them short the USD/JPY at 120.

Trader A chooses to apply 50 times real leverage on this trade by shorting US$500,000 worth of USD/JPY (50 x $10,000) based on their $10,000 trading capital. Because USD/JPY stands at 120, one pip of USD/JPY for one standard lot is worth approximately US$8.30, so one pip of USD/JPY for five standard lots is worth approximately US$41.50. If USD/JPY rises to 121, Trader A will lose 100 pips on this trade, which is equivalent to a loss of US$4,150. This single loss will represent a whopping 41.5% of their total trading capital.

Trader B is a more careful trader and decides to apply five times real leverage on this trade by shorting US$50,000 worth of USD/JPY (5 x $10,000) based on their $10,000 trading capital. That $50,000 worth of USD/JPY equals just one-half of one standard lot. If USD/JPY rises to 121, Trader B will lose 100 pips on this trade, which is equivalent to a loss of $415. This single loss represents 4.15% of their total trading capital.

This table shows how the trading accounts of these two traders compare after the 100-pip loss.

Trader ATrader B
Trading Capital$10,000$10,000
Real Leverage Used50 times5 times
Total Value of Transaction$500,000$50,000
In the Case of a 100-Pip Loss-$4,150-$415
% Loss of Trading Capital41.5%4.15%
% of Trading Capital Remaining58.5%95.8%

*All figures in U.S. dollars

How Does Forex Margin Compare to Stock Trading?

Leverage in the forex markets tends to be significantly larger than the 2:1 leverage commonly provided on equities and even the 15:1 leverage provided in the futures market. Although 100:1 leverage may seem extremely risky, the risk is significantly less when you consider that currency prices usually change by less than 1% during intraday trading (trading within one day

Are Forex Markets Volatile?

Forex markets are among the most liquid markets in the world. Hence, they tend to be less volatile than other markets, such as real estate. The volatility of a particular currency is a function of multiple factors, such as the politics and economics of its country. Therefore, events like economic instability in the form of a payment default or imbalance in trading relationships with another currency can result in significant volatility.

How Much Leverage Should I Use?

Traders should choose the level of leverage that makes them most comfortable. If you are conservative and don’t like taking many risks, or if you’re still learning how to trade currencies, a lower level of leverage like 5:1 or 10:1 might be more appropriate. More seasoned or risk-tolerant traders may be comfortable with 50:1 or 100:1+.

The Bottom Line

There's no need to be afraid of leverage once you have learned how to manage it. The only time leverage should never be used is if you take a hands-off approach to your trades. Otherwise, leverage can be used successfully and profitably with proper management. Like any sharp instrument, leverage must be handled carefully—once you learn to do this, you have no reason to worry.

Smaller amounts of real leverage applied to each trade affords more breathing room by setting a wider but reasonable stop and avoiding a higher loss of capital. A highly leveraged trade can quickly deplete your trading account if it goes against you, as you will rack up greater losses due to the bigger lot sizes. Keep in mind that leverage is totally flexible and customizable to each trader's needs.

Forex Leverage: A Double-Edged Sword (2024)

FAQs

Forex Leverage: A Double-Edged Sword? ›

Leverage, which is the use of borrowed money to invest, is very common in forex trading. By borrowing money from a broker, investors can trade larger positions in a currency. However, leverage is a double-edged sword, meaning it can also magnify losses.

Is leverage a double edge sword? ›

Financial leverage is therefore a double-edged sword as it has the advantage of reducing your cost of capital but also enhances your bankruptcy risk.

What is the most profitable leverage in forex? ›

Best leverage in forex trading depends on the capital owned by the trader. It is agreed that 1:100 to 1:200 is the best forex leverage ratio. Leverage of 1:100 means that with $500 in the account, the trader has $50,000 of credit funds provided by the broker to open trades.

What leverage is good for $100 forex? ›

Many professional traders say that the best leverage for $100 is 1:100. This means that your broker will offer $100 for every $100, meaning you can trade up to $100,000. However, this does not mean that with a 1:100 leverage ratio, you will not be exposed to risk.

Is 1/500 leverage good for a beginner? ›

Some may even offer leverage as high as 1:500. While this may seem enticing, it is not recommended for beginner traders. High leverage can lead to significant losses and should only be used by experienced traders who have a thorough understanding of the markets and proper risk management strategies.

What is an example of a double edged sword? ›

Example Sentences

He can wield energy as a weapon now, but it is already proving a double-edged sword. Still, Botox injections and facelifts are a double-edged sword. It cut Ruby as a double edged sword, for she understood that he cared well enough that way—æsthetically.

What does it mean to be a double-edged sword? ›

phrase. If you say that something is a double-edged sword, you mean that it has negative effects as well as positive effects. A person's looks are a double-edged sword. Sometimes it works in your favor, sometimes it works against you.

How much can you make with $1000 in forex? ›

First, however, let's assume you started day trading with a capital of $1000. In your strategy, you place a maximum of 15 trades a day (too many), lose 5 and win 10. You are looking at a total of 60 pips per day. As mentioned, you make roughly $20 a day.

What is leverage to get rich? ›

Leverage allows you to do more with less. It takes three things to build wealth: time, knowledge, and money. You can leverage any of these to amplify your returns. For example, if you use your knowledge to record a paid course, you will get paid every time someone purchases it.

How many lots can I trade with $10,000? ›

Therefore, with a $10,000 account and a 3% maximum risk per trade, you should leverage only up to 30 mini lots even though you may have the ability to trade more.

What is the safest leverage in forex? ›

For conservative investors, or new ones, a low leverage ratio of 5:1/10:1 may be good. For seasoned investors, who are more risk-friendly, leverages may be as high as 50:1 or even 100:1 plus.

What leverage should a beginner use? ›

As a new trader, you should consider limiting your leverage to a maximum of 10:1. Or to be really safe, 1:1. Trading with too high a leverage ratio is one of the most common errors made by new forex traders. Until you become more experienced, we strongly recommend that you trade with a lower ratio.

What happens if you lose leverage in forex? ›

When trading with leverage, you are essentially borrowing money from your Forex broker to finance your trade. If the value of your investment falls, you will not only lose the money that you have invested but also the money that you have borrowed.

Do you have to pay back leverage in forex? ›

In forex trading, traders do not have to "pay back" leverage in the traditional sense. Leverage allows traders to control larger positions but does not require them to repay borrowed funds. Instead, traders are responsible for managing the potential gains and losses associated with leveraged positions.

How risky is 1 500 leverage? ›

1:500 is an extremely high leverage. You would only need a trade to go slightly against you and your whole account will be wiped out. Remember, your LOSSES ARE MULTIPLIED BY 500 as well as your gains.

Can I trade 1 to 1 leverage? ›

Limited Risk Exposure: With 1:1 leverage, traders are shielded from the extreme risk of large losses that can result from higher leverage ratios. Since there are no borrowed funds at play, potential losses are confined to the trader's initial capital.

Is 1 500 leverage good for forex? ›

1:500 is an extremely high leverage. You would only need a trade to go slightly against you and your whole account will be wiped out. Remember, your LOSSES ARE MULTIPLIED BY 500 as well as your gains.

Is 1/500 leverage good? ›

1:500 leverage is a powerful tool that can potentially increase profits in the world of trading. However, it also comes with significant risks that traders must understand before utilizing it. It requires proper risk management and a thorough understanding of the market to avoid potential losses.

Is 1/1000 leverage good for beginners? ›

A leverage ratio of 1:1000 provides the highest level of amplification, allowing you to control positions that are 1000 times larger than your capital. This level of leverage carries significant risks and is generally not recommended for beginners.

Is 1:300 leverage good? ›

1:300 leverage in Forex means that for every $1 you have in your account, you can control a position worth $300. This can be a powerful tool for traders, as it allows them to amplify their profits. However, it is important to use leverage responsibly, as it can also amplify losses.

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