Forex trading is attractive to a lot of people. One of the reasons is that there is higher leverage in forex compared to other financial instruments, especially with stocks. While leverage trading is a common word with traders, only some know its definition, how it works and what is its direct impact.
Leverage implies borrowing a certain amount of funds that are required to invest in something. When it comes to stocks, a fund is usually borrowed from a broker. High leverage is offered in forex trading symbolically that for an initial margin requirement, a huge amount of money can be built-up or controlled by a trader.
Margin-based leverage is computed by dividing the total transaction value by the amount of margin that is needed to put up.
Margin-Based Leverage = Total Value of Transaction / Margin Needed
For an example:
A trader is required to deposit a margin that is 1% of the total transaction value. He plans to trade 1 standard lot of USD/EUR which is equal to US$100,000 and the margin needed is US$1,000. With this, the margin-based leverage will be 100:1 (100,000/1,000). If the margin needed is 0.25%, using the same formula, the margin-based leverage will be 400:1.
Still, margin-based leverage does not influence the risk. Any transaction value as a margin that the trader is required to put, whether it is 1% or 2%, it may not influence the profits or losses. This is due to the fact that the investor can always assign more than the needed margin for any position. This means that the stronger indicator of profit and loss is the real leverage and not the margin-based leverage.
Real leverage that is currently in use by the trader is computed by dividing the total face value of the open position by the trading capital.
Real Leverage = Total Value of Transaction/ Total Trading Capital
For an example:
If the trader has $10,000 in his account and he opens a $100,000 position (equal to 1 standard lot), he will trade with 10 times leverage on his account (100,000/10,000). If he will trade for 2 standard lots which have an equal worth of $200,000 in face value with just $10,000 in the account, then his leverage on the account is 20 times (200,000/10,000).
In conclusion, the margin-based leverage is equal to the highest real leverage a trader can use. The trader’s real leverage may differ from the margin-based leverage since they do not use the whole account as margin for each of their trades.
Mostly, a trader must not use all their available margin. They must only use leverage when the advantage is plainly on their side.
It is possible to know the potential loss of the capital once the amount of risk with reference to a number of pips is known. In a general rule, the loss must not be more than 3% of the trading capital. If for example, the position is leveraged to the point that the potential loss may be equal to 30% of the capital then, the leverage should be reduced.
The traders may also compute the level of margin that they should use. For example, the trader has $10,000 in his trading account and decided to trade 10 mini lots of USD/JPY. Each step of 1 pip in the mini account is worth $1. So, if he trades for 10 minis that will be worth $10, and 100 minis will be worth $100 for each pip step.
Therefore, 30 pips stop-loss represents a potential loss of $30 for 1 mini lot, $300 for 10 mini lots and $3,000 for 100 mini lots. With that, a $10,000 account and a 3% maximum risk per trade, leverage trading must be a maximum of 30 mini lots even if he can trade more.
