Forex Walkthrough

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Level 6 Trading - Leverage

As we've already learned, leverage in the forex market is a key factor in explaining why forex has become so popular. Forex trading offers high leverage in the sense that for a preliminary margin requirement, a trader can build up (and manage) a large amount of money.

Margin-Based Leverage
To determine margin-based leverage, divide the total transaction amount by the level of margin you are required to put up. (For more insight, check out Margin Trading.)

Margin-Based Leverage =
Total Value of Transaction
Margin Required


For example, if you're required to deposit 1% of the total transaction amount as margin and you are trading one standard lot of USD/JPY which is equivalent to US$100,000, the margin requirement is US$1,000. So, your margin-based leverage is 100:1 (100,000/1,000). For a margin requirement of 0.25%, the margin-based leverage is then 400:1.


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%



Now, we know margin-based leverage does not necessarily affect one's risks, because a trader's margin requirement may not influence his or her profits or losses. This is because trader can always allot more than their required margin for any position. What we need to look at is the real leverage, not margin-based leverage.

Real Leverage
To determine your real leverage, divide the total face value of your open positions by your trading capital.
Real Leverage =
Total Value of Transaction
Total Trading Capital


For example, if you have $10,000 in your trading account, and you open a $100,000 position (one standard lot), you will be trading with 10x leverage in your account (100,000/10,000). Now, if you trade two standard lots($200,000) with $10,000 in your account, then your leverage on the account is 20x (200,000/10,000).

This also means that the margin-based leverage is equivalent to the maximum real leverage you, as a trader, can use. And since the vast majority of traders don't use their entire accounts as margin for each and every one of their trades, their real leverage differs from their margin-based leverage.

Risk of Excessive Real Leverage
So as you can see,
real leverage has the ability to magnify your profits or losses by the same magnitude. The greater the leverage you use, the higher the risk that you take on. Keep in mind that this risk is not necessarily related to margin-based leverage, but it can influence if you're not careful.

Here's an example to illustrate this point (See Figure 1).

Let's say that both Trader X and Trader Y have a trading capital of US$10,000, and their broker requires a 1% margin deposit. After doing their analysis, they both agree that USD/JPY has reached a top and should fall in value soon. So both Trader X and Y short the USD/JPY at 120.

Trader X chooses to use 50x real leverage on his trade by shorting US$500,000 worth of USD/JPY (50 x $10,000) based on his $10,000 in trading capital. Because USD/JPY stands at 120, one pip of USD/JPY for one standard lot is worth roughly US$8.30, so one pip of USD/JPY for five standard lots is then worth about US$41.50. So, if USD/JPY rises to 121, Trader X will lose 100 pips on his trade, which equals a loss of US$4,150. This single loss represents a massive 41.5% of his total trading capital.

Trader Y was slightly more careful and decided to apply five times real leverage on his trade by shorting US$50,000 worth of USD/JPY (5 x $10,000) based on his $10,000 trading capital. That $50,000 worth of USD/JPY is only half of a standard lot. So if USD/JPY rises to 121, Trader Y will lose 100 pips on his trade, which equals to a loss of $415. Trader Y's loss represents only 4.15% of his total trading capital.

Take a look at the chart below to see how the trading accounts of these two traders compare after their 100-pip losses.



Trader X
Trader Y
Trading Capital
$10,000
$10,000
Real Leverage Used
50 times
5 times
Total Value of Transaction
$500,000
$50,000
In the Case of a 100-Pip Loss
-$4,150
-$415
% Loss of Trading Capital
41.5%
4.15%
% of Trading Capital Remaining
58.5%
95.8%
Figure 1: All figures in U.S. dollars



Excessive Leverage Can Kill
By allotting a lesser amount of real leverage on each trade, you can give your trade a little more room for error by setting a wider but reasonable stop thus avoiding risking too much of your money. Highly-leveraged trades that move in the wrong direction can eat up your capital quickly due to larger lot sizes. If you only remember one thing from this, remember that leverage is totally flexible and customizable to your needs, so be sure to use leverage wisely and don't go for that home-run every time.

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