What Is Leverage?
Leverage is a trading strategy that involves borrowing money to increase your trading capacity and investment power. While it increases your profit, it also increases your risks considerably.
Leverage is a technique that allows traders to borrow capital in order to invest in a currency, stock, or security and gain a larger exposure to the market.
While the potential to earn significantly higher profits may sound tempting, leverage also magnifies the losses just as dramatically.
Leverage trading is common in forex as the forex market offers some of the lowest margin rates compared to other leveraged assets, making it an attractive proposition for forex traders.
The forex market is huge but exchange rates change by very small increments, which are measured in hundredths of a cent or “pips”. For example, in the case of EUR/USD, the average daily change is between 40 to 100 pips or (0.4 to 1 cent per day more or less) for the past several years.
As a result, a trader would need to invest huge amounts in a trading position in order to see any noticeable change, which is usually way more than what an average retail trader has at their disposal.
The term leverage was first used during the industrial revolution to describe the increasing scope of an action using a physical lever. In 1933, the word entered the business world to denote the expansion of a business by mortgaging its assets for a loan.
To understand what leverage is in financial trading, you can look at it as mortgaging your funds to invest in an instrument. There’s no need for a direct relationship between what you mortgage and the size of the investment – in fact, most online brokers will open a position worth way more than your mortgaged assets; however, your profits and losses are relative to your investment and not the original sum that has been mortgaged.
In leverage trading, the level of increase is depicted as the ratio between the trader’s (margin) investment and the size of the position the broker consequently opens.
For example, a 400:1 leverage means that for every dollar invested, the position opened is equivalent to $400, while a 20:1 leverage means that for every dollar invested, the position size is $20, and so on.
The Flip-Side of Leverage – Margin
When trading with an online CFDs broker, money is not deducted from your account when you open a position. Instead, only when you close the position will profit be added or losses subtracted from your balance.
Meanwhile, your money will be divided into used margin and free margin. Used margin refers to the amount of your money that is mortgaged to your open positions, while free margin is the amount of money that you can still use to open new positions.
The third type of margin is required margin, which refers to the amount of free margin you must have to open a specific new position. Required margin is calculated by a position size and your leverage, and it is quoted as a percentage that is inversely proportional to the leverage on an instrument.
For example, if you are opening a €10,000 position (1 mini lot) on the EUR/USD with 400:1 leverage, you will be required to mortgage 1/400 (0.0025%) of the position size. Thus, €25 required margin.
The moment the position is opened, the required margin is added to your used margin and subtracted from your free margin. Since most positions are opened at a loss due to the broker’s bid/ask spread (the difference between the sell and buy rates offered), that loss (which is already leveraged) is also deducted from the free margin and added to your used margin. This dynamic continues for as long as the position accrues losses or profits – it is always relative to the tune of your leveraged position size.
Where’s the problem?
Leverage affects not only the position size but also the trader’s subsequent profit or loss on a position.
If a trader invests $1 in a position, a 100-pip movement in the currency pair’s value – 1 cent, in the case of the EURUSD pair, for example – translates into a $4 movement in the case of 400:1 leverage. Where this is profit, clearly there is no problem; where it is a loss, the trader has lost 4 times his/her investment, which could come as a sobering surprise, considering that most brokers’ minimum forex position equals 10,000 units, or €10,000, for the EURUSD pair.
Now, consider that, with 400:1 leverage, the trader’s investment equals the equivalent of (10000/400=) €25, discovering a €100 loss on what seems to be a 1-cent movement can be quite disconcerting!
Control your Leverage with Self-Select
In general, leverage is pre-selected by your broker, based on the level of your trading status. Retail traders receive anywhere between 2:1 and 30:1 leverage depending on the asset class and instrument, while professional traders can get anything up to 400:1, considering that their required experience and resources can afford them that level of risk.
If you want to lower your leverage, you need to contact your account manager and have him/her change your leverage per account. Once that’s done, traders can determine their leverage and risk level for each and every separate trade. It’s simply a matter of making a selection and confirming the position.
It is important to remember that once your position has been opened, you can no longer change that parameter, since your margin levels (used and free) are already in flux.