How leverage is used in Forex trading?

“Leverage” in general terms simply means, borrowed resources. Leverage is widely used to acquire not only physical assets such as real estate or cars, but also to trade financial assets such as stocks and foreign currency (“forex”).

Trading in Forex securities by individual investors has grown by leaps and bounds in recent years, thanks to the proliferation of online brokerage platforms and the availability of cheap credit. The use of leverage in securities transactions is often considered a double-edged sword as it magnifies profits and losses. This is even more noticeable in Forex transactions where high degrees of leverage are the norm. The examples in the next section illustrate how leverage magnifies returns on profitable and unprofitable trades.

leverage in Forex brokerage

Examples of leverage in Forex

Let’s assume that you are a US based investor and have an account with an online Forex broker. Your broker provides you with the maximum leverage allowed in the United States in currencies at a 50: 1 ratio, which means that for every dollar you place, you can trade up to $ 50 of a major currency. You put up to $ 5,000 as margin, which is the collateral or shares in your brokerage account. This means that you can put up to $ 250,000 ($ 5,000 x 50) in currency positions initially. This amount will obviously fluctuate depending on the profits or losses that are generated from the transactions. (To keep things simple, we ignore commissions, interest and other charges in these examples)

Example 1: Long in USD / Short in Euro. Transaction amount = EUR 100,000
Let’s assume that you initiated this transaction when the exchange rate was EUR 1 = USD 1.3600 (EUR / USD = 1.36), since you expected a decline in the European currency in the short term.

Leverage: Your leverage on this transaction is 27: 1 ($ 136,000 / $ 5,000 = 27.2, to be exact)

Pip Value: Because the Euro is quoted to four decimal places, each “pip” or basic point that moves in the Euro is equal to 1 / 100th of 1% or 0.01% of the amount traded in the base currency. The value of each pip is expressed in USD, since this is the reference change. In this case, based on the amount traded of EUR 100,000, each pip is worth USD 10. (If the amount traded were EUR 1 million against USD, each pip would be worth USD 100.)

Loss Limit: Since you are testing the waters regarding Forex trading, you set a 50 pip loss limit on your long USD / short EUR position. This means that if the Stop Loss is activated, your maximum loss is $ 500.

Profit / Loss: Fortunately, you are lucky as a beginner and the Euro falls to a level of EUR 1 = USD 1.3400 within a couple of days of the transaction. You close the position with a profit of 200 pips (1.3600 – 1.3400), which translates to USD 2,000 (200 pips x USD 10 per pip).

Forex Math

In conventional terms, you shorted EUR 100,000 and received USD 136,000 in your opening trade. When you closed your transaction, you bought back the Euros you were short at a lower rate of 1.3400, paying USD 134,000 for EUR 100,000. The $ 2,000 difference represents your gross profit.

Effect of Leverage: Using leverage, you were able to generate a 40% return on your initial investment of USD 5,000. What if you had traded $ 5,000 without using any leverage? In that case, you would only have shorted the Euro equivalent of USD 5,000 or EUR 3,676.47 (USD 5,000 / 1.3600). The significantly lower amount of this transaction means that each pip is only worth $ 0.36764. Closing the short Euro position at 1.3400 would then have resulted in a gross profit of $ 73.53 (200 pips x $ 0.36764 per pip). Using leverage, he was able to magnify his returns exactly 27.2 times ($ 2,000 / $ 73.53), or the amount of leverage used in the transaction.

Example 2: Short USD / Long Japanese Yen. Amount Traded = $ 200,000
40% Earned on your first leveraged Forex trade that you did before motivates you to trade more. It focuses on the Japanese Yen (JPY), which is trading at 85 against the USD (USD / JPY = 85). You expect the Yen to strengthen against the USD, so you initiate a short USD / position and a long Yen position in the amount of USD 200,000. The success of your first transaction has motivated you to trade a larger amount, as you now have $ 7,000 as margin in your account. Although it is a substantially higher amount than the previous trade, you are comfortable with the fact that it is within the maximum amount you could trade (based on 50: 1 leverage) of $ 350,000.

Leverage: Your leverage rate for this transaction is 28.57 ($ 200,000 / $ 7,000).

Pip value: The yen is quoted to two decimal places so that each pipen in this transaction is worth 1% of the base currency expressed in the reference currency, or 2,000 yen.

Loss limit: You set a loss limit on this transaction at JPY 87 against the USD, as the yen is very volatile and you don’t want your position to get out of the way because of random noise.

Remember, you are long in the Yen and short in the USD, so ideally you would like the Yen to appreciate against the USD, which means that you could close your short USD position with less Yen and record a profit on the difference. But if your stop loss kicks in, your loss would be substantial: 200 pips x 2,000 yen per pip = JPY 400,000 / 87 = $ 4,597.70.

Profit / Loss: Unfortunately, reports of a new fiscal stimulus package unveiled by the Japanese government lead to a weakening of the Yen, and your stop loss kicks in one day after putting your long trade in JPY. Your loss in this case is $ 4,597.70 as explained above.

Forex math:

In conventional terms, the math looks like this:
Open position: Short USD 200,000 @ USD 1 = JPY 85, ie + JPY 17 million

Closing position: Activating the stop loss results in a hedged short position of USD 200,000 @ USD 1 = JPY 87, ie – JPY 17.4 million

The difference of JPY 400,000 is your net loss, with an exchange rate of 87, it translates to USD 4,597.70.

Leverage effect: In this example, using leverage magnified your losses, which amount to 65.7% of your total margin of $ 7,000. What if you had only short $ 7,000 against the Yen (@ USD1 = JPY 85) without using any leverage? The lower amount of this transaction means that each pip is worth only JPY 70. The stop loss activated at 87 would have resulted in a loss of JPY 14,000 (200 pips x JPY 70 per pip). Using leverage they magnified their losses by exactly 28.57 times (JPY 400,000 / JPY 14,000), or the amount of leverage used in the trade.

Tips when using Leverage

While the prospect of making huge profits without putting in a lot of money is tempting, always keep in mind that excessively high leverage can result in you losing your shirt and more. A few precautions used by professional brokers can help you mitigate the inherent risks of trading leveraged Forex:

  • Limit your losses: If you hope to make big profits one day, you must first learn to reduce your losses. Confining your losses to manageable limits before they get out of hand and drastically erode your wealth.
  • Use strategic stops: Strategic stops are of the greatest importance in the Forex Market, where you can go to sleep and wake up the next day to see that your position has been adversely affected by a movement of a couple hundred pips. Stops can be used not only to ensure that losses are kept under control, but also to protect profits.
  • Do not lose control of the situation: Do not try to get out of a losing position, doubling it or averaging it. The biggest losses in securities trading have occurred due to a broker jamming with his guns and continuing to expose himself to a losing position until he becomes so large that he cannot emerge unscathed from a catastrophic loss. The broker’s vision might eventually have been correct, but it was usually too late to resolve the situation. It is far better to cut your losses and keep your account alive for another day, rather than wait for an unlikely miracle than to reverse a huge loss.
  • Use appropriate leverage as far as you feel comfortable: Using 50: 1 leverage means that a 2% adverse move could wipe out your entire margin. If you are a relatively cautious investor or broker, use a lower level of leverage that keeps you comfortable, perhaps 5: 1 or 10: 1.

conclusion

Although the high degree of leverage inherent in Forex magnifies returns and risks, using a few safety precautions used by professional brokers can help mitigate those risks.

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