Forex Leverage: A Double-Edged Sword

Forex Leverage: A Double-Edged Sword

One of the reasons so many people are attracted to trading forex compared to other financial instruments is that with forex, you can usually get much higher leverage than you would with stocks. While many traders have heard of the word “leverage,” few know its definition, how leverage works, and how it can directly impact their bottom line.

The concept of using other people’s money to enter a transaction can also be applied to the forex markets. In this article, we’ll explore the benefits of using borrowed capital for trading and examine why employing leverage in your forex trading strategy can be a double-edged sword.

Key Takeaways

  Leverage is the use of borrowed funds to increase one’s trading position beyond what would be available from their cash balance alone.

  Brokerage accounts allow the use of leverage through margin trading, where the broker provides the borrowed funds.

  Forex traders often use leverage to profit from relatively small price changes in currency pairs.

  Leverage, however, can amplify both profits as well as losses.Defining Leverage 

Leverage involves borrowing a certain amount of the money needed to invest in something. In the case of forex, money is usually borrowed from a broker. Forex trading does offer high leverage in the sense that for an initial margin requirement, a trader can build up—and control—a huge amount of money.

To calculate margin-based leverage, divide the total transaction value by the amount of margin you are required to put up:

Margin-Based Leverage = Total Value of Transaction / Margin Required

For example, if you are required to deposit 1% of the total transaction value as margin and you intend to trade one standard lot of USD/CHF, which is equivalent to US$100,000, the margin required would be US$1,000. Thus, your margin-based leverage will be 100:1 (100,000/1,000). For a margin requirement of just 0.25%, the margin-based leverage will be 400:1, using the same formula.

Margin-Based Leverage Expressed as Ratio Margin Required of Total Transaction Value 400:1 0.25% 200:1 0.50% 100:1 1.00% 50:1 2.00%

However, margin-based leverage does not necessarily affect risk, and whether a trader is required to put up 1% or 2% of the transaction value as margin may not influence their profits or losses. This is because the investor can always attribute more than the required margin for any position. This indicates that the real leverage, not margin-based leverage, is the stronger indicator of profit and loss. If you want a simple thing, just visit this Calculadora de pips Forex.