What leverage should I choose for Forex trading?
What is leverage and margin trading on Forex? How do I calculate leverage? What leverage should I choose? You will find answers to these and other questions in this article.
Hello, friends! After talking with traders, not only beginners, but even those who have been trading Forex for quite a long time, we came to the conclusion that many of them do not understand what leverage is and how to use it correctly in trading. Therefore, we decided to devote a separate article to this issue, from which you will learn what margin trading and leverage on Forex are, which leverage to choose depending on the strategy, in which cases it is better to trade without leverage, and how to calculate leverage.
See also the independent rating of Forex brokers with real reviews of traders.
Forex leverage – what is it?
As you already know, a broker is an intermediary between trading participants (traders) and the exchange. Brokers are companies that provide trading platforms for making deals that allow private clients to trade on global markets. If you have already tried Forex trading, you may have noticed that most of the time the prices of currency pairs slightly change their course, slowly creep up or down. And only sometimes there are jumps in the exchange rate. If you have a small Deposit, then you will earn very little on such a small price movement, and you can wait for sharp changes in the exchange rate for a very long time, and it is extremely difficult to predict them.
In this case, you will benefit from the broker's service, which is called "leverage"or" margin trading". This service is provided for trading currency pairs, stocks, indices, CFDs, cryptocurrencies, and other trading instruments. So what is leverage and how do I use it? If you want to buy a car or an apartment, but you do not have enough money for this, then you go to the Bank and get a loan secured by the purchased propertytion. This scheme also works on the exchange, you can enter into transactions with leverage, and the volume of such transactions will be much higher than if you opened transactions without leverage. Thus, leverage is a tool that allows you to enter into transactions for an amount that is many times higher than your own funds on the trading account. For example, your Deposit is $ 1000, and with a leverage of 1:100, you can enter into transactions for up to$100,000.
The amount of leverage is the ratio of own funds to borrowed funds. In the stock market, leverage is usually 1:1, but sometimes it can be increased to 1:5. in Forex, the standard leverage is 1:100, but more often brokers offer leverage of 1:500 and even 1: 1000 to attract new clients.
See also which brokers have the lowest spread.
Leverage and collateral
Many traders are interested in the question of how a broker insures itself against the risk of losing borrowed funds during margin trading. The answer is very simple. When opening a trade, the broker takes a Deposit, which is calculated from the volume of the opened position, but can not exceed the size of your Deposit. If the price went in the wrong direction, and the amount of losses is close to the amount of your Deposit, then all transactions will be forcibly closed. This situation in the market is called Stop Out, it is preceded by a Margin Call. In those days when there was no Internet and all transactions were made over the phone, the broker called the client and warned that his losses were approaching the amount of collateral. But now none of the brokers are calling, and in fact Margin Call and Stop Out can be considered one concept.
How do I calculate leverage?
Let's look at how leverage works in the following example. Let's say you have$ 10,000 in your account and the broker has given you a leverage of 1:100. We will buy EURUSD. It should be noted here that we can't buy or sellbuy as much currency as we want, for example, 325 euros, or we can buy and sell the amount of currency that is a multiple of lots. The standard EURUSD lot is equal to 100,000 units of the base currency, in our case 100,000 euros. If you want to buy 2 lots of EURUSD, you need 200,000 euros. But this does not mean that you need to buy only whole lots, the broker allows you to trade fractional parts, for example, 0.1 lots (10,000 euros) or 0.01 lots (1,000 euros).
For example, you decided to buy 2 lots of EURUSD at the price of 1.42976. Since the Deposit is in dollars, you buy 2 × 100 000 × 1,42976 = 285 952$. At the same time, you may have a very natural question: how can you buy$ 285,952 with only$10,000 in your account? The fact is that the broker has provided you with a leverage of 1:100, and to make a deal you only need 1/100 of the standard lot, i.e.$2,859. 52. But you need to remember that you are spending$ 2,859. 52 of your own funds, but in fact you are buying$285,952. If you look in the Trade tab of the MetaTrader 4 trading terminal, you can see the following values of your trading account:
- Balance – the amount of the Deposit including all closed transactions. Since this is our first trade and the profit or loss on it has not yet been recorded, we see the initial amount of$10,000 in the Balance field;
- Equity is the account's cash, taking into account the current profit or loss. We see that the current profit on the trade is$ 50, so Equity = $10,050;
- Margin is the broker's collateral when opening a trade using leverage, Margin = (2 × 100 000 × 1,42976) / 100 = 2 859,52$, where 100 is the amount of leverage;
- Free margin-shows the amount of free funds to open new deals, Free margin = Equity-Margin = 10 050 – 2 859,52 = 7 190,48$;>
- Margin level – the level calculated using the formula: Equity / Margin × 100% = 10 050 / 2 859,52 × 100% = 351,46%.
Thus, the trading account can be divided into two parts: collateral and free funds. If the price goes in our direction, the Free margin will increase, and if the price moves against us, the Free margin will decrease, while the amount of collateral does not change. As a result, with a leverage of 1:100, we can trade with only 1/100 of the transaction, meaning you risk only$ 1,429.76 (for 1 lot) instead of$142,976. Without leverage, Forex trading would require huge amounts of money, and the profit would be very small.
If you look at the screenshot above, you can see that the price increased from 1.42976 to 1.43001, and the current profit was$ 50 or 25 points. If we opened a deal with 1 lot, the profit would be$25. Thus, we get a universal formula for calculating profit / loss for five-digit quotes:
1 lot = 1 point = 1 dollar
This formula is read as follows: if you bought 1 lot and the price changed by 1 point, then you earned or lost 1 dollar. If you bought 1 lot and the price changed by 25 points, you will earn or lose $ 25, and so on. In practice, thanks to this formula, you can look at the chart, measure the distance that the price can go in one direction or another, and assess the risks so as not to buy too much and not lose your Deposit if the price goes against you. If you have a small Deposit, then nothing prevents you from buying 0.1 lots, then 1 point will be equal to $ 0.1, which significantly reduces your risks.
Consider the following situation. For example, you bought not 2, but 6 lots of EURUSD at the price of 1.42976, that is, the total Deposit was:
Margin = (6 × 100 000 × 1,42976) / 100 = 8 578,56$.
In this case, cothe number of available funds will be:
Free margin = 10 000 – 8 578,56 = 1 421,44$.
In this case, our formula will look like this:
6 lots = 1 point = 6 dollars.
Let's say you bought 1 lot and see that the price may fall by 300 points to the next strong support level, then the risk in this transaction will be $ 300. And if you bought 6 lots, the risk is already $ 1,800, which is too much for a Deposit of $ 10,000.
The danger of leverage is that if we open a lot of trades, and the total collateral on your account will remain 20-30% of the funds (each broker has its own requirements), then there will be a Margin Call, and the broker will be forced to close all your trades at the current price, which will actually lead to the loss of the Deposit. To avoid this, you need to follow money management, that is, do not overload your Deposit with large volumes of transactions, and monitor the Margin level in MT4.
When buying 1 lot, the level was Margin level = 10 050 / 2 859,52 × 100% = 351,46%.
When buying 6 lots Margin level = 10 000 / 8 578,56 × 100% = 117,15%.
As soon as the Margin level approaches the 20 – 30% mark, the Margin Call will occur. Therefore, it is important to monitor the Margin level, if it has fallen below 100%, then this is a signal that you need to take measures to save the Deposit from being drained. There are two ways to do this. Either top up your Deposit immediately, if you are sure that the situation can improve soon, or close the deal with the biggest loss. But it is better not to bring it to this, and follow the money management.
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High leverage-harm or benefit?
Many traders have a negative view of a large leverage ratio. They believe that the higher the leverage, the higher the risk of draining the Deposit. However, this is not entirely true. The amount of leverage does not affect earningswhether it's a loss or not, it affects the collateral. The higher the leverage, the lower the collateral, and the more positions you can open. For example, if you bought 1 lot of EURUSD at the price of 1.42976, the Deposit for a leverage of 1:100 will be$ 1,429. 76, for 1:200 – $ 714.88, for 1:500 - $285.95. However, leverage has no effect on profit or loss. If you bought 1 lot of EURUSD and the price passed 300 points (for five-digit quotes), you will earn$ 300 regardless of whether you use 1:100 or 1:200 leverage.
The risk of maximum leverage is that if you buy a currency pair for the entire Deposit, then if the price moves against you, you will very quickly lose all your funds. If you follow the money management, and the risk per trade will not exceed 1% of the Deposit, that is, the stop loss should be no more than$ 100 with a Deposit of $ 10,000, then you will never lose the Deposit, no matter how much leverage you trade. From my personal experience, 1:100 leverage is enough for Forex trading. The exception is scalping or martingale, when you need to open a large number of trades, then you will need a leverage of 1:500.
See also which broker to choose for scalping.
Leverage in the foreign exchange market differs from other exchanges (for example, the stock market) in that it is very large here, and this has given Forex a reputation as the most risky market. Therefore, it is extremely important to use leverage correctly. Only in this case, the broker's leverage will play a positive role. If you do not use leverage correctly and open transactions for the entire Deposit, you can quickly lose money in the foreign exchange market. Therefore, you need to understand what leverage is, how it works, what it affects, and what effect it has on your trading account. The best leverage is 1:100, and it's up to you to decide which leverage is best.
Read also the article " Which timeframe to choose on Forex?».