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Leverage in Finance and Trading: Forex, Stock, Crypto

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FxNews – This is J.J. Edwards, and in this article, I will help you understand leverage in trading securities such as forex, stocks, and cryptocurrencies. You’ll find out how to calculate leverage and look at its good and bad sides. I will also show you how to lower the forex trading risks by adjusting your trade volumes wisely.

Leverage is key in forex trading. Trading with leverage is a privilege. It lets traders control bigger positions with smaller cash. But we should be careful; misusing leverage can lead to a tremendous loss. This article is about understanding how leverage works and how to mix leverage with wisdom for successful trading.

What is Leverage in Forex Trading?

What is Leverage in Trading

What is Leverage in Trading

Leverage is a ratio. This ratio lets you trade more money than you actually have. Let’s say you have $1,000. With a 100:1 leverage, you can handle $100,000 in trades. This means, with just one dollar, you can trade $100. There are different leverage ratios. These include 50:1, 100:1, or even 500:1. They show how much you can control in the market with a small amount. But it’s important to know, using higher leverage affects your balance more if the market changes.

Example: Imagine you’re a forex trader with a $500 account. You decide to use a leverage of 100:1. This means you’re now able to trade up to $50,000, even though your actual funds are much less. In this scenario, each dollar in your account is effectively acting like $100 in the market. It’s like having a magnifying glass that makes your trading power a hundred times bigger than your real money.

Now, consider the market moves in your favor and your trade gains value. Even a small percentage increase on the $50,000 position leads to a significant profit, much more than what a $500 position would have earned. However, the risk is equally magnified. If the market moves against you, losses will also be amplified, and they can quickly exceed your original $500. This high-stakes situation highlights why leverage is both a powerful and a risky tool in forex trading.

Leverage Calculation Formula Explained

how to calculate leverage

how to calculate leverage

To figure out leverage, divide your position’s total value by your account balance.

Say you have $1,000 and open a $50,000 position; your leverage is 50:1. Another way to calculate it is through margin, which is a required percentage of your position’s value in your account. The formula for this is 100 divided by the margin percentage. You can also utilize our automated margin calculator for free.

Leverage Calculation Formula

Leverage Calculation Formula

Example 1 for calculating leverage: First, look at the broker’s leverage ratio, like 50:1, 100:1, or 200:1. For instance, 100:1 means with $1 of your money, you can handle $100 worth of trading. To find out how much money you can manage with leverage, multiply your account balance by the leverage ratio. If your account has $1,000 and you use 100:1 leverage, you can handle $100,000 worth of trades.

This ratio also sets the margin requirement, which is cash you need in your account to keep a position open. With 100:1 leverage, you need 1% of the total trade value as margin. So, for a $100,000 position, you need $1,000 as margin. Remember, leverage can increase both profits and losses. If the market goes against you, you could lose a lot. Managing this risk is key in forex trading.

Example 2 for calculating leverage: Let’s say you start with $1,000 in your forex account. You choose to use 100:1 leverage, as offered by your broker. This means you can trade $100 for every $1 you own.

With this leverage, your $1,000 turns into a $100,000 trading position. It’s your $1,000, but 100 times bigger because of the leverage.

Now, here’s the important part: If the currency’s value rises by 1%, your gains are on the $100,000. That’s a $1,000 profit, doubling what you started with. However, if the value drops by 1%, you lose $1,000. This clears out your account. That’s how leverage is risky. It can increase your earnings, but it can also lead to big losses.

Forex Leverage for Beginners: A Comprehensive Guide

Forex Leverage for beginners

Forex Leverage for Beginners: A Comprehensive Guide

Newcomers to forex trading, who aim to gradually build up a passive income, often have one common question: What leverage should I use?

The fact is that the answer depends on several factors. They include elements such as your balance, the securities you plan to trade, your broker, and your risk management and trading strategies.

Forex brokers often offer high leverage to traders who possess a small balance. That is because they can’t trade with a small amount of money like $10 or $100. The equity is just too low. Therefore, I don’t see any issues with picking a moderate leverage for your account. In my opinion, as long as traders use stop loss in their orders, and they don’t risk more than 1% of their account in each trade, a high leverage won’t cause issues, but it boosts your trading experience.

A leverage of 1:400 is neither too high nor too low, and with $500 in your balance, you will be able to execute new orders and manage your trades smoothly.

While leverages are significant high for major forex pairs such as EUR/USD, GBP/USD, and USD/JPY, the offered leverage is much less in other securities and CFD products. For example, the leverage for trading precious metals like gold and silver is usually half of forex. That means if your leverage is 1:1000 for trading the major currency pair, your leverage would be 1:500 on gold or less depend on your broker’s leverage policy.

The table below shows the recommended leverage for trading forex with different balances.

Balance

Leverage

0 - $1000

1:1000

$1,001 - $4,999

1:400

$5,000 - $9,999

1:1200

$10,000 and more

1:100

The reason behind leverage reduction is that some securities or trading instruments don’t have enough liquidity. The daily trading volume for EURUSD is much greater than less traded currency pairs such as USDRAN (U.S dollar or South African Rand). Therefore popular securities have more leverage because there is more liquidity available.

The same sort of rules apply to cryptocurrencies. Even though cryptocurrency trading has been buzzing in the last few years, the market liquidity is not as large as that of precious metals and currency pairs. Therefore, the leverage for trading cryptocurrencies is usually 10 times less than that for forex. For example, if your leverage for trading GBPUSD is 1:1000, you can’t open a trade on Bitcoin with leverage greater than 1:10.

That said, you should read and study the website of your broker to know what you are walking into.

The Pros and Cons of Using Leverage

The Pros and Cons of Using Leverage

The Pros and Cons of Using Leverage

Leverage’s main perk is trading big with less money, potentially boosting profits. Imagine using 100:1 leverage on a $100,000 position with $1,000; a 1% favorable market shift can double your investment. But a 1% shift against you can mean a 100% loss. If the market keeps moving against you, you might face a margin call, where the broker asks you to add funds or close positions.

What is the Best Leverage?

Choosing the best leverage for yourself is something personal and depends on several factors:

  • Risk Tolerance: How much loss can you handle?
  • Trading Approach: What is your trading frequency, position duration, and financial goals?
  • Market Behavior: Consider the market’s volatility and liquidity.
  • Broker’s Conditions: Look at the leverage limits and associated costs set by your broker.

Before you choose your leverage with your broker, think about these questions.

It’s important to carefully plan how you will trade. If you trade often and quickly, making small profits, using higher leverage might be good for you. However, if you’re a swing or day trader, leverage isn’t as important. You can manage your trades with lower leverage, like 1:200, based on your account balance. Remember, swing and day traders sometimes hold their positions overnight. Therefore, you should also think about the swap charges your broker might apply.

If you’re just starting out, don’t like risks, trade infrequently, or work in unpredictable markets, go for less leverage. Those who are seasoned, okay with risks, trade often, or are in stable markets can go for more leverage.

However, keep in mind that leverage isn’t a surefire way to succeed. It helps in achieving goals but also brings more risk (How Forex Hedge Can Mitigate Risk).

Be careful with leverage and never bet more than what you can handle losing.

  • 10 November 2023
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