The Whole Truth About Leverage in Forex

Concerning comments in forums, it seems that a lot of people do not understand what leverage in Forex market is. Moreover, there is a myth among new traders just beginning that the bigger the leverage is, the higher the risks. Let’s try to see if it’s true or not.

First of all let’s see what a forex leverage indeed is. Leverage can be of various sizes: 1:10, 1:20, 1:50, 1:100, 1:500 and even 1:1000. A broker providing us a leverage allow us trade bigger lots than we would let ourselves. It can increase our gross (or losses if it goes against our position).

Let’s take an example: John has a deposit of $5000 and then decides to trade 1 lot currency pair USDJPY. While trading 1 lot, John practically uses 100.000 $ for trade. If leverage is provided to him 1:100, a 1000 $ deposit is reserved by John’s account. That is 1:100 leverage power.

A lot of people would ask – and how would the broker insure himself from losing his money? Easily: a potential loss of John is limited by the sum which is in his account. Let’s try to investigate how it would be if a price would go against John’s prognosis and his opened position would bring loss.

Let’s imagine that a John’s loss position is opened and has already reached 4000 $ (John’s deposit was 5000 $); a broker can call John and ask to fund deposit or close a part of a loss position. That’s called Margin Call (sometimes Stop Out). Of course, in these computer eras nobody is going to call you and a loss position which reaches a broker determined limit level will be closed automatically without any notification.

 

When does Margin Call occur?

Therefore, as have been established already, 1000 $ deposit is taken from John’s opened position. A market is going against John’s position (which costs 100.000 $) and opened (floating loss) reaches 4000 $.

It means that John’s account balance (Equity) is 5000 – 4000 = 1000 $.

As soon as funds in the account are equal or smaller than a required deposit, a Margin Call will occur. A Margin Call can differ depending on a broker or an account type, but most usually it is 20-50 % from a required deposit. I.e. when funds in an account are becoming smaller up to, let’s say, 30 % from a required deposit size, an automatic position close occur.

Let’s say a margin call in John’s account occurred. In this case, when a position closed (with a 4500 $ loss), its value amounted to: 1000 $ (John’s initial deposit) + 99000 $ (which were added by a broker as a credit) – 4500 $ (a loss) = 95500 $.

The broker will take all the money plus those 3500 $ which lack so that he could get back 99000 $ which he borrowed to John. This way the trader John will fully take a loss, in whose account after Margin Call will be only 500 $.

By analogy, if a position was profitable, John would take the whole gross as soon as position is closed. For example, John is borrowing 99000 $ from a broker and leaves 1000 $ deposit and his position brings 8000 $ gross. As soon as a position is closed, John has 99000 $ + 1000 $ + 8000 $ =108000 $.

After a closed position 99000 $ will be sent back to a broker, 1000 $ deposit will go back to John’s account and 8000 $ gross will also be deposited in John’s account.

That’s what forex leverage is – as a double-edged sword it can either turn your small deposit into scads of money or end your account in one second 🙂

 

Let’s switch to a myth about large leverage injury

Let’s imagine that they’re two accounts: one is provided with leverage 1:100; other 1:500. We open the same positions in both accounts, let’s say, we buy 0.01 size lots EURUSD. A question: which account brings higher risks? An answer: The risk is the same. Let’s say, we’ve lost 100 pips to 0.01 lots, therefore, it will be 10 $, will defeat of the amount increase or decrease depending on leverage size? No way.

In general, a huge leverage let open positions of big volumes when having a small deposit. And nothing else. If your risk level is adequate, if you follow smart capital management principles, a leverage 1:500 or 1:1000 changes absolutely nothing.

But if you have decided to play roulette like in casino and opened a position by big lots, and did not keep the money management or hang any robot working by martingale principle, then yes – a huge leverage will let you have fun until Margin Call occurs.

Let’s discuss findings – a leverage size does not make any influence on risk level in Forex market. A risk level is influenced only by position size which is determined by the trader himself and nobody else.

Take care and good trading.