Forex brokers lend money to traders so that they can increase their investments in the foreign exchange market. Leverage is therefore essentially the borrowing of money from a broker to increase one's return on investment. However, this also means that a trader increases his or her risk of losing more money.
Leverage is partly responsible for the popularity of forex trading since traders can easily choose the level of risk they wish to take with a reduced amount of capital.
Forex brokers can afford to offer leverage because the losses are limited to the trader's balance (the money he has deposited to his account). To keep the balance of a trader's account from being negative, brokers close a trader's positions if his account margin is unable to cover the loss. This is called a margin call or a stop out.
In forex trading, it is therefore possible to trade sums of money in excess of the initial deposit through leverage, but your losses cannot exceed the balance of your account.
How does leverage work in forex?
The amount of money invested in a position is determined by the size of a lot. Typically, a standard lot is 100,000 units of the base currency (the currency on the left, ex: 100,000 euros for a EUR/USD position). Buying 1 lot of EUR/USD at 1.2500 is therefore equivalent to buying 100,000 euros that have a value of $125,000 (100,000 x 1.2500). It is also possible to purchase fractional lots, for example 0.10 lot = 10,000 units.
The change in price of a currency pair is expressed in "pips", a variation of 1 pip is equal to 0.0001. In our example of the purchase of 1 lot of EUR/USD, each variation of 1 pip is equal to $10 or the equivalent in euros for an account with a balance in euros (0.0001 x 100,000 = $10). If the trade moves 10 pips, the trader earns or loses $100, depending on the direction taken by the market.
The amounts invested may seem huge to retail traders, but leverage solves this problem. To use leverage, a trader must have a certain amount of equity which represents the margin, this minimum amount varies among brokers.
With leverage of 100:1, you only need to have €1,000 in margin to take on a €100,000 position, with leverage of 500:1, the required margin is only €200. Note that some brokers offer leverage higher than 500:1, but most professional traders will not use leverage higher than 10:1, as it greatly increases the risk of loss, especially if you have a small account that cannot withstand unrealised losses.
The danger of leverage
A common mistake beginning forex traders make is to use leverage without taking into account the risk in relation to the amount of money available in their trading account. Leverage can wipe out a trading account very quickly if it is not handled properly.
For example, if a trader has a $1,000 trading account and uses 100:1 leverage, each 1-pip movement is worth $10. If his stop is set 10 pips away from the entry point and it is hit, the trader loses $100, or 10% of his trading account. A reasonable trader generally will not risk more than 3% of his account on a position if he follows strict money management rules.
Limiting risk with money management
If risk management rules are properly used, the level of leverage is not important.
Traders base their risk on a percentage of their account's total balance. In other words, the risk on each trade is the same regardless of the amount of leverage used.
A trader that has a $1,000 trading account and a stop loss set at 10 pips can use 10:1 leverage with a position of 0.10 lot. Thus, each pip is worth $1 and the risk taken on the trade is $10 or just 1% of the account.
Risk must be calculated according to one's account balance, the size of the position and the stop loss level.
The impact of leverage on trading costs
Forex brokers make money from spreads or from commissions earned on trading volumes. Leverage increases brokers' income since traders who use high leverage increase their trading volume (and their risk of losing).
For example, if a trader opens an account with $1,000 and decides to buy 1 standard lot of EUR/USD with a spread of 2 pips, he uses leverage of 100:1 and each pip is worth $10. The cost of the trade is $20 (the 2-pip spread), which already represents 2% of his account. This level is unsustainable and this is one of the reasons why traders who use leverage without considering risk in relation to a percentage of their capital tend to lose their capital quickly.
A competent trader that respects risk management rules (ex: no more than 3% on a trade) will use a maximum leverage of 10:1, where each pip is worth $1. In this case, the cost of each trade is $2, or 0.20% of the account. He can therefore set his stop loss correctly in order to not exceed a 3% risk.
The key points to remember
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