XM does not provide services to residents of the United States of America.

XM does not provide services to residents of the United States of America.

Forex Leverage: Definition, Examples, Risks

“Leverage is like a magnifying glass for your trading potential; used wisely, it can turn small insights into substantial gains.”

Imagine you are playing a game where you are throwing heavy pebbles on a sandy beach. The deeper the mark your pebble leaves on the sand, the higher the points you get.

Now, imagine there is a big group of people swimming in the sea. If you use a lever, you can move one of the heavier rocks, which means that you can leave a deeper mark on the sand. However, if you do not aim well, there is also the risk of hitting the people who are swimming in the water.

The heavier the rock your lever allows you to lift, the more considerable the points you could collect in the game, but also the injury you could cause the people in the sea.

Financial leverage is not far off from this scenario. It is one of the aspects of forex trading that makes it attractive to traders worldwide, while also being one of the aspects that makes it high-risk.

Are you curious about what leverage is and how it relates to the hypothetical game we described above? Read on to find out more.

What Is Leverage?

Think of leverage as the act of borrowing funds from your broker in order to amplify your position in the market. For instance, let’s say that you are trading with a capital of $1,000 and your broker offers you a leverage of 100:1. With your broker’s leverage, you can control a position that is worth $100,000 ($1,000 x 100), which is the equivalent of 1 standard lot. In other words, you are controlling a position that is 100 times larger than what your initial capital would have allowed you to control.

This means that the outcome of your trade will also be larger. And therein lies the appeal of using leverage. Imagine you have bought 100 times more of an asset than you would have bought using your capital alone. If its value goes up, you will have made 100 times more profit. If its value goes down, you will have suffered 100 times more loss.

It’s exactly like the hypothetical game we mentioned above. With a heavier rock, you collect more points if you hit the sand. However, if you hit a person in the water, you end up with a bigger injury. Similarly, with leverage, with a greater position size, you make a bigger profit if the market moves in your favour. However, if the market moves against you, you end up with a bigger loss.

What Is Margin?

Margin refers to the amount of money required to open and maintain a leveraged position in the market. Remember your initial capital of $1,000 from the example above? That would be the money you would put down as collateral when you open your position. In other words, this initial deposit acts as a security for the borrowed funds provided by your broker.

Leverage in Forex Trading

Now that you know what leverage is, let’s go over some examples to understand how it works in forex trading.

Assume that you want to buy 10,000 units (1 mini lot) of EUR/USD at an exchange rate of 1.2000. To buy 10,000 EUR with USD, you need to invest:

10,000 x 1.2000 = 12,000 USD

Unleveraged Trade Example

In the first scenario, you decide to execute your trade without using leverage. You therefore invest the full $12,000 yourself.

The market moves in your favour and the exchange rate rises to 1.2100. You decide to close your position and realise your profit; so, you sell the 10,000 EUR, and you buy back 12,100 USD.

10,000 x 1.2100 (new exchange rate) = 12,100 USD

At the end of this exchange, you walk away with a profit of:

$12,100 – $12,000 = $100

If the market were to move against you, and the exchange rate were to fall to 1.1900, you would have sold your 10,000 EUR, and you would have bought back 11,900 USD.

10,000 x 1.1900 (new exchange rate) = 11,900 USD

This means that you would have walked away with a loss of:

$11,900 – $12,000 = -$100

Leveraged Trade Example

Now let’s assume, in this second scenario, that you chose to execute your trade with a leverage of 30:1. This means that you can open your position by investing only:

$12,000 / 30 = $400

Now remember, you are only investing $400 but you are holding a position worth $12,000 with the help of the borrowed funds from your broker.

Like in the unleveraged trade example, you buy 10,000 EUR with your 12,000 USD position size. And when the exchange rate rises to 1.2100, you sell your 10,000 EUR back and close your profit at the price of 12,100 USD.

10,000 x 1.2100 (new exchange rate) = 12,100 USD

Similar to the unleveraged scenario above, you walk away with a profit of:

$12,100 – $12,000 = $100

Needless to say, the same would happen if the market were to move against you. Let’s assume that the exchange rate falls to 1.1900. You, therefore, sell your 10,000 EUR for 11,900 USD.

10,000 x 1.1900 (new exchange rate) = 11,900 USD

In this case, you walk away with a loss of:

$11,900 – $12,000 = -$100

As you can see, the amount of profit or loss is the same in both scenarios. However, in the leveraged trade, the initial investment is $400, while in the unleveraged one, it is $12,000. The leveraged trade therefore brings a return (or loss) of 25%, while the unleveraged trade brings a return (or loss) of only 0.83%.

Leverage Ratios and Margin Requirements

You will have noticed from our examples that leverage is shown as a ratio (eg., 30:1 or 100:1). Common leverage ratios include 30:1, 50:1, 100:1, and 200:1. A leverage ratio of 50:1 means that for every $1 of equity, the trader can control $50 in the market.

Margin, on the other hand, is usually expressed as a percentage of the full position size. For example, with a 50:1 leverage ratio, the margin requirement is 2% of the total position size. So, if a trader were to open a position worth $10,000 with a 50:1 leverage, they would need an initial margin of $200 (2% of $10,000).

The relationship between leverage and margin is inverse. That is to say, higher leverage ratios mean lower margin requirements. For example, a 100:1 leverage ratio requires a 1% margin, whereas a 50:1 leverage ratio requires a 2% margin. This distinction is worth keeping in mind because some brokers quote their margin requirement rather than their leverage ratio in their advertisements.

Leverage Ratio	Margin Requirement
400:1	0.25%
200:1	0.50%
100:1	1.00%
50:1	2.00%
20:1	5.00%

Risks of Trading With Leverage

Potential Losses

Trading with leverage amplifies both potential gains and potential losses. While it allows traders to control large positions with a relatively small amount of capital, it also means that even minor market movements can have a significant impact on the trader’s equity.

For example, a leverage ratio of 30:1 means that a 1% move in the market can result in a 30% change in the trader’s account balance. Let’s assume that you are holding a position worth $90,000 with a 30:1 leverage ratio, and the margin you put down as collateral is $3,000. A 1% move in the market would result in a 1% move in your $90,000 position, meaning there would be a change of $900 in your account balance. Relative to your $3,000 investment, a $900 change would amount to a 30% move in your account.

This amplification effect means that while profits can be substantial, losses can quickly accumulate, potentially leading to the loss of the entire invested capital. It’s crucial for traders to fully understand the risks involved and to employ effective risk management strategies.

Margin Calls

A margin call occurs when a trader’s account equity falls below the required margin, prompting the broker to request additional funds to cover potential losses. If the trader is unable to meet the margin call, the broker may close some or all of the trader’s positions to bring the account back to the required margin level.

Traders aim to avoid margin calls altogether because they force them to either deposit more funds into their account or have their positions liquidated by the broker. This can happen unexpectedly and at times when the market is moving against you, which can result in significant losses. That’s why it’s important to maintain sufficient margin levels and employ effective risk management strategies.

Managing Risk When Trading With Leverage

So, what are these effective risk management strategies we keep talking about? Let’s go over them one by one.

Maintaining Adequate Margin Levels

There are a variety of metrics that show you how healthy your account is. For example, margin level is a metric that indicates the amount of equity relative to the used margin in your trading account. In other words, it is the ratio of your entire account balance to the portion of your account that is currently tied up in open trades.

The margin level helps you understand how much of your funds are available for new trades and how close you are to receiving a margin call. A higher margin level, for instance, indicates a healthier account with more available funds relative to the used margin.

By keeping these levels in check, you can maintain a healthy account balance, and better navigate the market’s volatility.

Implementing Stop-Loss Orders

Another risk management strategy when trading with leverage is the use of stop-loss orders. These orders automatically close a position when the market moves against you by a predetermined amount.

By setting a stop-loss, you can limit your losses and protect your capital from severe downturns. It’s a disciplined approach that helps ensure that your losses are manageable and that you can stay in the market for the long term. However, it is important to keep in mind that stop losses may not work effectively during periods of extreme market volatility, or when there is a gap in the market, such as over the weekend or after major news events.

Implementing Take-Profit Orders

A take-profit order automatically closes a trade when the price reaches a specified level, securing profits without the trader needing to constantly monitor the market. This strategy ensures that gains are locked in, preventing the risk of potential reversals that could turn profitable trades into losses.

By setting predefined profit targets, you can better plan your trading strategies, maintain discipline, and avoid emotional decision-making, all of which contribute to more effective risk management.

Final Thoughts

At the end of the day, leverage is like a magnifying glass for your trading potential; used wisely, it can turn small insights into substantial gains. However, it is also, as they say, a double-edged sword. It changes the size and outcome of your trades in a similar way to the pebbles in our hypothetical game on the beach. With the use of leverage, you can amplify your potential profits, but you also need to accept the fact that you are amplifying your potential losses.

To manage the risk of higher losses, you should keep an eye on your margin levels, make sure that your account has a healthy balance, and use stop-loss and take-profit orders to maintain discipline in your strategies.

Ready to Start Trading?

Access a wide range of assets with a global broker by your side. Buy and sell currencies, stocks, indices, commodities and much more on our user-friendly and innovative platforms.

Open an account with XM

Frequently Asked Questions

1. What is a good leverage in forex trading?

A good leverage will depend on your trading goals and risk tolerance. Additionally, the leverage you use will be determined by the country you live in as there are rules and regulations. For instance, the highest leverage you can use in the EU is 30:1.

2. How much leverage should beginners start with?

Beginners should start with low leverage, typically around 10:1 or even lower, such as 5:1. This conservative approach amplifies potential losses by less and allows them to gain experience without taking on excessive risk. Alternatively, they can practise their strategies in a virtual environment using a demo account.

3. How much leverage is risky?

Leverage is always risky. High ratios of leverage can especially amplify losses by a large amount. This means that a small adverse move in the market can result in significant losses and potentially wipe out the trading account quickly.