Leverage in forex trading effectively allows you to trade with more money than you actually have. This means you stand to gain more money from profitable trades. However, it can just as easily work against you. In this article, we’ll explain how it works.
Leverage in forex trading explained
Traders make money due to changes in the exchange rates between foreign currencies. However, these changes are usually really small. So small in fact, they are typically measured in hundredths of a cent or penny. We call these hundredths “pips”.
An obvious way to take advantage of these changes is to trade with relatively large sums of money. That’s why the standard measurement for measuring the size of a trade is a “lot”. One lot is equivalent to one hundred thousand units of the base currency – whether the base currency is American or Canadian dollars, Euros, or British pounds.
But of course, the problem here is that most people do not actually have several hundred thousand dollars or pounds or francs with which they can start trading.
That’s where leverage comes in.
How does it work?
Leverage solves this problem by plugging the gap between the money you’d ideally like to trade with, and the money you actually have. It’s not a credit or a loan – the money is never transferred to you. Instead, it is basically assigned to your trade when you open it.
Leverage is expressed as a ratio, for example, 1:100. This means that, for every $1 or £1 or whichever currency your account is in, your broker assigns you the other $99.
Here’s a quick example.
You have $10,000 in your account. You want to take out a 1 lot buy trade on USDCHF.
1 lot equals 100,000 units of the base currency – in this case, that’s 100,000 USD.
Obviously you don’t have 100k in your account, but since the leverage on your account is 1:100, you can open this trade with just $1,000. Your broker assigns you the remaining $99,000.
The amount of money you need from your account to open a trade and keep it open is called the margin.
Leverage in action
Using the above example, let’s say you bought 1 lot of USDCHF at 0.98829. You closed the trade at 0.99029, which is 20 pip gain. At the time of writing, this would mean a profit of $202.37.
Thanks to leverage, you made over $200 from a $100,000 trade – even though you only had $10,000 in your account.
The downside
If you were to look up the definition of “double-edged sword” in the dictionary, we’re pretty sure leverage in forex trading would be an example of it.
That’s because leverage will magnify your losses just as easily as it will magnify your gains.
Repeating the above example again, let’s say you bought 1 lot of USDCHF at 0.98829. But this time, the price fell 20 pips to to 0.98629 and hit your stop loss.
You would have lost $202.37 – exactly the same amount as if you were trading with $100,000 of your own money.
What this means
Obviously nobody wants to lose money, but the above example only resulted in a loss of $200. That’s acceptable in terms of standard risk management practices, which state that you should never risk more than 1-2% of your account balance per trade.
High leverage forex brokers
1:100 is pretty high leverage, but it’s far from the highest available. Some forex brokers offer 1:200, 1:300, 1:400, 1:500 or even 1:888 leverage.
Of course, the high the leverage there is on an account, the smaller the margin it takes to open a trade.
1 to 500 leverage means that you would be able to open the above trade with just $200 of your own money.
And using the above example, the same $1,000 margin would allow you to open a 5 lot trade.
While it’s true in this case that a 20 pip gain would bring you $1,000, a 20 pip loss would cause you to lose $1,000, which would be terrible.
Technically speaking, this leverage would even allow you to open a 15 lot trade using a $3,000 margin. But the same 20 pip loss here would cost you a whopping $3,000, which, on a $10,000 account, would be a complete disaster.
Hopefully now, you start to realize how dangerous leverage can be. It makes it really easy to open large trades that have the potential to decimate your account in the blink of an eye. Add poor risk management and no strategy, and you can literally lose money faster than you can burn it.