What is Leverage in Forex?

Understanding how leverage works in forex is essential to being successful as a forex trader. The availability of high leverage is the primary reason why making money in forex has so much potential.

If you open a margin account with a stock broker, then you may be able to trade with up to twice as much money as what you actually have in your account. However, in forex all brokers offer a minimum of 50 times leverage, which has a significant impact on possible gains and losses.

To understand leverage, we need to first understand the basics of a margin account.

Related: Stocks vs Forex: Why Trade Forex?

Leverage in Forex: What is a Margin Account?

A margin account is basically a hybrid of a brokerage account and a credit account (think of a Credit Card). However, unlike a credit account, which allows you to borrow money without any reserved financial collateral, a margin account requires for a certain amount of funds to be held as collateral depending on the level of leverage.

This amount held as collateral is called margin – hence the name Margin Account.

In the stock market, margin accounts may allow 2:1 leverage, which means a trader can take a position twice as large as the amount of money they have in their account. If they have $1,000 then they can trade with $2,000.

This extra $1,000 is borrowed money (credit) on which the trader incurs interest, on a daily basis. However, the interest incurred is often significantly smaller than the potential gains obtained from trading with double your capital.

Basically all traders ignore the small interest charges when trading on margin - the benefit of margin trading greatly outweighs the interest cost.

In contrast, in forex all brokers offer a minimum of 50:1 leverage, which means a trader can take a position that is 50 times larger than the amount of money they have in their account. If they have $1,000 then they can trade with up to $50,000 units.

Now, you may think that the interest on the borrowed $49,000 would be significantly higher, but in reality the incurred daily interest even with 50x leverage is extremely low compared to potential profit.

Generally, daily interest paid is less than the cost of the spread.

Furthermore, because forex traders are actually trading currencies, sometimes the interest can be positive since they are borrowing one currency in order to invest in another. If the borrowed currency has a lower interest rate than the invested currency, then the trader will receive a positive interest rate.

In forex, the daily interest is called Swap, and forex swap can be positive on some currency pairs. Granted, again this daily interest (whether positive or negative) is very small, so basically all forex traders ignore it, due to its insignificance compared to potential gains and losses.

Now that we understand how a margin account works, let's examine how leverage affects profit and losses.

How Leverage Works in Forex

The basic idea of how leverage works is that if a trader uses 50:1 leverage then they are able to trade with $50,000 when they only have $1,000 as collateral. This means that their profit and loss are based on trading with $50,000 instead of $1,000.

If a forex trader only traded with $1,000 then 100 pips of profit would only be $10 profit. However, if that forex trader uses 50:1 leverage and trades with $50,000 then 100 pips of profit would be $500 profit (50 times larger). By using 50x leverage, a trader with $1,000 could potentially make $500 from 100 pips, which is a 50% gain.

Earning 200 pips would cause the trader’s money to double ($1,000 gain) with 50:1 leverage.

Risks Associated with High Leverage in Forex

However, there are dangers of using high leverage too, because losses are likewise based on the larger trade size.

To illustrate, here are what profit and losses would look like for a $2,000 account based on different levels of leverage: 1x, 25x, and 50x.

Leverage is often referred to as a double-edge sword, because it can both accelerate gains and escalate losses. This is the reason why leverage management is important in forex, because a -50% loss on one trade is not sustainable long-term. Most consistently profitable forex traders use less than 10:1 leverage, which is equivalent to using only 20% of your money with 50:1 leverage.

If you have $2,000 and use 10:1 leverage, then the trade size is:

• $2,000 x 1.00 = $2,000 (100%)
• $2,000 x 10 = $20,000 (10x)

If you have $2,000 and use 20% of your money with 50:1 leverage, then the trade size is:

• $2,000 x 0.2 = $400 (20%)
• $400 x 50 = $20,000 (50x)

I personally prefer to keep my account at 50:1 leverage, but generally use less than 20% of my margin for trading in order to artificially use less than 10:1 leverage. The primary reason why I take this approach is to avoid a margin closeout.

Leverage in Forex: What is a Margin Closeout?

A margin closeout is when your forex broker closes your trades because you do not have sufficient margin to support the trade size. For example, if you have $2,000 in your account and trade with 100% at 10:1 leverage, then you will likely receive a Margin Closeout Warning if your trade is even slightly negative.

• Account Value: $2,000
• Account Leverage: 10x
• Margin Used: $2,000 (100%)
  
• Trade Size: $20,000
• Profit/Loss per Pip: $2

Imagine that your trade is currently -2 pips which is -$4 of unrealized loss. This negative value affects your available margin, even though it is technically unrealized until the trade is closed.

From your broker’s perspective, you have $2,000 margin with a -$4 unrealized loss, which translates to $1,996 margin available. However, with an account leverage limit of 10:1 and a trade size of $20,000 you are required to have a minimum of $2,000 as margin.

Thus, you receive a Margin Closeout warning, because you have insufficient margin available.

Margin Closeout Rules

Your forex broker will generally allow up to 3 days for you to resolve the issue, before they force-close your trade at the current market price. One option is for you to deposit more funds to meet the minimum margin requirement for your trade size, which you may be required to do depending on the situation.

However, another option is for you to not do anything if the trade goes in your favor, because if the -2 pips turns into +2 pips then you will have sufficient margin from unrealized profit ($2,004 margin available). A third option is to increase your account’s leverage ratio to 20:1 or 50:1 in order to have lower margin requirements; however, this is not an option if you are already at the maximum leverage allowed.

Also, even if you resolve the Margin Closeout warning before the 3 days are up, the Closeout warning will still remain on your record with your forex broker.

Alternatively, if you have $2,000 as margin but only use 20% with 50:1 leverage you would not be in danger of a Margin Closeout warning for a long time even though you have the same trade size as someone using an account limit of 10:1 leverage.

• Account Value: $2,000
• Account Leverage: 50x
• Margin Used: $400 (20%)
• Trade Size: $20,000
• Profit/Loss per Pip: $2

Now when you are -2 pips on a trade in unrealized losses, your account value will appear like $1,996 to the broker, but you still have plenty of margin to meet the $400 minimum margin requirement.

You would have to be at least -800 pips to be in danger of a Margin Closeout warning (which should never happen – you need to cut your losers off at some point if you want to be successful in forex – never trade without a stop-loss of some kind).

Leverage Management in Forex

Why trade with only 20% with 50:1 leverage?

Because trading with anything over 20:1 leverage (or 40% of your money with 50:1 leverage) is not sustainable long-term. If you want to be successful long-term then leverage management is absolutely necessary, and you can certainly Win in Forex with much less leverage.

Get more great stuff like this delivered to your inbox