What leverage should you choose to trade in Forex?
What is leverage and margin trading on Forex? How to calculate the leverage? What leverage to choose? You will find answers to these and other questions in this article.
Hello friends! After talking with traders, not only with newbies, but even with those who have been trading forex long enough, 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 question, from which you will learn what margin trading and leverage in Forex are, what leverage to choose depending on strategies , in which cases it is better to trade without leverage, as well as how to calculate leverage.
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Leverage at Forex - what is it?
As you already know, the broker is an intermediary between participants of trade (traders) and the exchange. Brokers are companies that provide trading platforms for making deals that enable private clients to trade in global markets. If you have already tried to trade on Forex, you may have noticed that most of the time, the prices of currency pairs slightly change their course, slowly creeping up or down. And only occasionally there are jumps in exchange rates. If you have a small deposit, then on such a small price movement you earn very little, and you can wait for a sharp change in the exchange rate for a very long time, and it is extremely difficult to predict them.
In this case, you will benefit from a broker’s service called “leverage” or “margin trading”. This service is available for trading currency pairs, stocks, indices, CFD contracts, cryptocurrency and others trading tools. So what is a leverage, and how to 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 there on the security of the acquired property. This scheme works on the stock 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 many times greater than your own funds in a trading account. For example, your deposit is $1000, with a leverage of 1:100, you can enter into transactions for up to $100,000.
Leverage is the ratio of equity to debt. In the stock market, leverage is usually 1:1, but sometimes it can be increased to 1:5. At Forex, the standard leverage is 1:100, but increasingly, brokers offer a leverage of 1:500 and even 1:1000 to attract new customers.
See also, what are brokers with a minimum spread .
Leverage and Margin
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 transaction, the broker takes a deposit, which is calculated on the volume of the position being opened, but cannot exceed the size of your deposit. If the price does not go in your direction, and the amount of losses approaches the amount of your deposit, then all transactions will be forcibly closed. This market situation is called Stop Out, preceded by a Margin Call. In those days, when there was no Internet, and all transactions were made on 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 already calling, and in fact Margin Call and Stop Out can be considered one concept.
How to calculate leverage?
Consider how leverage works, using the following example. Suppose your account is $10,000, and the broker provided you with a leverage of 1:100. We will buy EURUSD. It should be noted here that we cannot buy or sell as much currency as we wanted, for example, 325 euros, but we can buy and sell a quantity of currency multiple to lots. The standard lot of EURUSD is 100,000 units of the base currency, in our case 100,000 euros. If you want to buy 2 lots of EURUSD, then you need 200,000 euros. But this does not mean that you need to buy only whole lots, the broker allows you to trade in fractional parts, for example, 0.1 lots (10,000 euros) or 0.01 lots (1,000 euros).
For example, you decide to buy 2 lots of EURUSD at a price of 1.42976. Since the deposit is in dollars, then you buy 2 × 100 000 × 1.42976 = $285,952. In this case, you may have a completely logical question, how can you buy $285,952, having only $10,000 in your account? The fact is that the broker provided you with a leverage of 1:100, and you only need 1/100 of the standard lot, that is, $2,859.52, to complete the transaction. But at the same time you need to remember that you are spending $2,859.52 of your own money, 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, taking into account all closed transactions. Since this is our first transaction and the profit or loss on it has not yet been fixed, we see the initial amount of $10,000 in the Balance field;
- Equity is the cash in the account with current profit or loss. We see that the current profit on the transaction is $50, so Equity = $10,050;
- Margin is the broker's pledge when opening a transaction 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 for opening new deals, Free margin = Equity - Margin = 10,050 - 2,859.52 = $7,190.48;
- Margin level - level calculated by the formula: Equity / Margin × 100% = 10 050/2 859.52 × 100% = 351.46%.
Thus, a trading account can be divided into two parts: a pledge and free funds. If the price goes our way, then the Free margin will increase, and if the price moves against us, then the Free margin will decrease, while the size of the deposit does not change. As a result, with a leverage of 1:100, we can trade, spending only 1/100 of the transaction, that is, you risk only $1,429.76 (for 1 lot) instead of $142,976. Without leverage, Forex trading would require huge amounts of money, and profits 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, then the profit was $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 has changed by 1 point, then you have earned or lost 1 dollar. If you bought 1 lot, and the price has changed by 25 points, then you will earn or lose $25, etc. 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 in order not to buy too much and not to lose the deposit if the price goes against you. If you have a small deposit, then nothing bothers you to buy 0.1 lot, 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 a price of 1.42976, that is, the total margin was:
Margin = (6 × 100 000 × 1.42976) / 100 = $8,578.56.
At the same time, the amount of free 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.
Suppose you bought 1 lot and see that the price could 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 lies in the fact that if we open a lot of transactions, and 20-30% of the funds remain in your account from the total deposit (each broker has his own requirements), then Margin Call will come and the broker will be forced to close everything your transactions at the current price, which will actually lead to a loss of the deposit. To avoid this, it is necessary to observe money management, that is, do not overload your deposit with large volumes of transactions, and follow the Margin level in MT4.
With the purchase of 1 lot the level was Margin level = 10 050/2 859.52 × 100% = 351.46%.
With the purchase of 6 lots Margin level = 10 000/8 578.56 × 100% = 117.15%.
As soon as the Margin level approaches 20 - 30%, Margin Call will come. Therefore, it is important to monitor the Margin level, if it fell below 100%, then this is a signal that you need to take measures to save the deposit from draining. There are two ways. Either immediately replenish the deposit, if you are sure that the situation can be corrected soon, or close the deal with the biggest loss. But it is better not to bring this up, and to observe money management.
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Big leverage - harm or benefit?
Many traders have a negative perception of high leverage. They believe that the greater the leverage, the higher the risk to drain the deposit. However, this is not quite true. The amount of leverage does not affect profit or loss, it affects the margin. The more leverage, the less collateral, and more positions you can open. For example, if you bought 1 lot of EURUSD at a price of 1,42976, then the pledge with a leverage of 1:100 is $1,429.76, with 1:200 - $714.88, with 1:500 - $285.95. But 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), then you will earn $300 regardless of whether you use the leverage - 1:100 or 1:200.
The risk of maximum leverage is that if you buy a currency pair for the entire deposit, then when the price moves against you, you will very quickly lose all your funds. If you observe money management, and the risk per transaction does 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 what leverage did not trade. From personal practice, 1:100 leverage is enough for Forex trading. The exception is scalping or martingale, when you need to open a large number of transactions, then you will need a leverage of 1:500.
See also which scalping broker is better to choose.
Leverage in the foreign exchange market differs from other stock exchanges (for example, the stock market) in that it is very large here, and this gave Forex its reputation as the most risky market. Therefore, it is imperative to use leverage correctly. Only in this case, the broker's leverage will play a positive role. If you do not use the leverage correctly and open transactions for the entire deposit, you can very quickly lose money in the foreign exchange market. Therefore, it is necessary to understand what leverage is, how it works, what it affects and what effect it has on a trading account. The most optimal leverage is 1:100, and which leverage is better to choose is up to you.
Read also the article “What timeframe to choose on Forex?” .