In foreign exchange trading, leverage is the name given to resources (usually either capital or financial instruments) that are borrowed by a trader from their broker to help fund a trade, investment or project, with a view to ultimately amplifying the return of that investment.
The leverage relied upon for a particular transaction can be described as the ratio of the trader’s actual funds invested in the deal to the size of the broker’s credit, which covers the remainder of the total cost.
A useful tool utilised by both retail and institutional traders, leverage is essentially a loan provided by the dealer to a client that enables them to trade with much higher sums of currency than their present capital alone would allow. In fact, the term ‘leverage’ is actually derived from the metaphorical image of using a lever to lift a heavier weight than you would otherwise be able to.
The specific terms, rates and requirements for leverage are not fixed across every brokerage firm, and can vary wildly depending on the conditions offered by the individual broker, the trader’s experience and the number of units involved.
Position Sizes, Leverage Ratios and Margins: How are They Connected?
Forex leverage is typically expressed as the ratio of the ‘margin’ — the word for the actual currency put down by the trader for the trade, analogous to a deposit or down payment — to the total exposure, or the total size of the position being traded.
For example, leverage of 1:100 means that the broker is willing to magnify your initial margin deposit by a hundred times; in other words, for every $1 you put forward, the dealer will let you trade with $100.
The margin required to enter a particular trade is usually only a small proportion of the total value, i.e. one or two percent. In practice, this means that if you were wanting to take control of a $50,000 position, you’d be required to put down $1,000 up front if the margin requirement was 2%.
This gives traders the advantage of being able to trade large sums of currency with a small amount of personal capital — for instance, a $1,000 deposit with a 1% margin requirement bolstered by a leverage ratio of 1:100 means you’d be able to assume control of a $100,000 position, despite only offering a thousand of your own dollars as a down payment.
Leverage Trading Terminology: An Overview
In addition to the basic notions of leverage and margin, there are also numerous surrounding concepts that specifically relate to how your chosen level of exposure affects your (potential and actual) gains and losses, and ultimately the net amount of funds you have available for trading.
These are key to understanding the risks of trading with different position sizes and margins, and are often displayed in trading platforms in real time for your convenience — in MetaTrader 4 for example, they’re listed at the bottom of your trading window under the market charts.
They are as follows:
- Balance is the amount of real money sitting in your trading account before you open any trades.
- Equity is the balance in your account, plus or minus the total floating profits or losses from all of your open positions. For example, if you have an account balance of $1,000 and your open trades are currently netting a profit of $250, your total equity would be $1,250 — on the other hand, if your open positions are making a loss overall, then your equity would be lower than your balance value. If you have no open trades at the moment, your balance and equity figures are therefore identical.
- Margin is the amount set aside as a deposit for the positions you currently have open; these funds are no longer available to you and are kept by the broker — it can be thought of as a form of commission for facilitating the trade.
- Free margin is the amount of usable money you have left in your virtual ‘down payment pot’ available to use to initiate more trades. Importantly, these funds will also be used to cover the negative value of any losing trades you have open in order to stop the value of your account falling; conversely, the good news is it will also increase if and when your account grows due to profitable trades.
- Margin level is the strength (or ‘health’) of your trading account at that particular moment. When you hit a certain percentage — which is stated in your account agreement, typically around 30% — your broker will close all your open positions due to insufficient funds; this event is known as a ‘margin call’ and essentially represents game over for your trading account at this time. Therefore, the higher the margin level, the better!
What are the Risks and Benefits of Leverage?
As discussed above, leverage is considered an indispensable financial aid by traders around the world, as it affords them access to — and control over — substantial volumes of currency that vastly dwarf their own available funds.
However, the use of leverage is a double-edged sword; the increased exposure has the potential to both multiply your profits and amplify your losses significantly — and it goes without saying that the higher the leverage, the higher the risk!
Consequently, traders using leverage almost always employ one or more risk management strategies to help keep any losses they incur as minor as possible.
For inexperienced traders, it is often advised that you keep your trade volumes small and trade only with micro lots and mini lots. That way, you won’t need to use as much margin to fund the trades — meaning your free margin has a far higher likelihood of staying at a healthy level — and your vulnerability to potential drops in the value of the currency you’re trading will be less extreme.
