HOW FOREX LEVERAGE WORK
Leverage is an important concept in forex trading, it is a term used to describe when traders borrow funds in order to open trade positions.
It is an amount that a trader borrows from broker in order to open a trade position in forex market. By borrowing money from broker, a trader can trade larger position in the market.
A trader with small capital cannot participate in forex market without leverage.
For example: A capital of 100 USD or 50 USD is too small to open trade position without the use of leverage.
They are written in ratio: 1:1, 1:2, 1:30, 1:100, 1: 400
For example: 1:100 means for every 1 USD you deposit, a broker will borrow you 100 USD.
MARGIN
Margin is the fund that a trader needs to deposit in order to open and maintain a trading position.
The amount deposited by a trader (margin) act as a security for borrowed money.
Margin act as a supportive amount that when deposited, leverage will be activated. Leveraged margin create a channel of many opportunities for a trader in forex market.
HOW DOES LEVERAGE AND MARGIN WORK IN FOREX TRADING
With leverage you can control large position using little amount of your own and borrowing the rest.
For example,
A trader has selected a leverage of 1:100, and has deposited a margin of $1,000, so the amount that will act as a borrowed money:
1,000 from margin×100 from leverage
=$100,000
With only a small amount of $1,000, you can trade as if you have $100,000, now the trader has a purchasing power of $100,000.
Another example
A trader selects a leverage of 1:1, and has deposited a margin of $1,000, so the purchasing power will remain 1,000, because a leverage of 1:1 will have no effect on $1000.
In order to have larger opportunities in the market, you need to use leverage.
HOW IS LEVERAGE USED BY FOREX BROKERS?
When dealing with brokers, they often specify a maximum leverage ratio, such as 1:400, but this limit may not apply uniformly across all trading instrument, as different brokers have varying policies regarding leverage usage. Instruments are financial assets that are being traded in forex market.
Example: Pairs, Indices and Metals
In their website a broker may specify each instrument and their maximum leverage
Example:
| Instrument | maximum leverage |
| Pairs | 1:400 |
| Indices | 1:200 |
| Metals | 1:50 |
| Commodities | 1:20 |
| Crypto currencies | 1:30 |
Why do they specify maximum leverage in each instrument?
This is because the brokers are limited in their registration regulations, this involves the aspect of setting maximum leverage limits in each instrument that brokers can offer to their clients.
LEVERAGE AND CAPITAL
In forex trading brokers, when a trader selects high leverage and deposits large amount of capital for example $500,000, most broker automatically reduce the maximum leverage to a lower level in response to the higher capital deposit high amount of capital.
Example: A broker may set
$1 - $10,000, maximum leverage is $1:500
$10,000 - $1,000,000, maximum leverage is $1:50
$1,000,000 to and above, maximum leverage is $1:5
LEVERAGE AND LOTSIZE
To trade with a standard lot size of 1, which earns $10 for one pip price movement, you would typically need 100,000 units of currency- an amount that most traders can’t afford. So here comes the importance of leverage.
How do we get the units?
For instance,
A trader deposits $1,000
For a trader to control a unit size of 100,000
A trader needs to use a leverage of 1:100
By taking 100 from leverage × 1000 from margin
=100,000
Therefore, from $1000 deposit a trader needs to use a leverage of 1:100 to have controlling power of 100,000 which make it possible to use a standard lot size of 1.
Factors to consider when choosing leverage
- Trading style
Example:
Scalpers are short-term traders who open trades for seconds to a few minutes. In order to maximize profits within a very short period of time, a trader with limited capital needs to select high leverage to gain greater exposure in the market.
A swing trader, is someone who remains active in the forex market for a day or even couple of weeks. Therefore, a trader typically uses standard leverage to manage their capital effectively.
- Trading Budget
If you deposit high capital, for example, 200,000 USD, you don't require high leverage; therefore, it’s likely you will select a lower leverage. However, a trader with a smaller capital base needs to opt for higher leverage to obtain many opportunities in the market.
- Trading Budget
If you deposit high capital, for example, 200,000 USD, you don't require high leverage; therefore, it’s likely you will select a lower leverage. However, a trader with a smaller capital base needs to opt for higher leverage to obtain many opportunities in the market.