Leverage is the use of borrowed money (called capital) to invest in a currency, stock, or security. Using leverage increases traders’ flexibility when trading on Forex. Since Forex lots can be huge, leverage allows trading larger lots and opening more positions without putting all your equity into one colossal trade.
It’s easier to understand through an example. Suppose you want to buy one GOOGLE stock worth $2000, but your capital is only $200. If you use 1:10 leverage, your $200 will turn into $2000, and you will be able to buy this stock. In this case, out of the 100% of the trade amount, you provide only 10%, while your broker provides the other 90%.
What is Leverage Ratio
The leverage ratio represents the position value to the investment amount required. FBS offers leverage of up to 3000:1. However, it varies depending on jurisdiction and the asset class.
With 1000:1 leverage, you can control a $100 000 trade position with just $100, where a 1% positive price change in the market will result in a profit of $1000 (1% of $100 000). Without leverage, a 1% positive price movement will result in a gain of only $1 (1% of $100). With 1000:1 leverage trade positions, the resulting profits/losses are multiplied 1000 times.
An important aspect is understanding how to calculate the leverage ratio. The following formula is commonly used and easy to remember:
L = A/M
where L is leverage, M is the margin amount and A is the trade amount.
However, the calculation of the margin amount M is more necessary for the trader.
M = A/L
Example:
The trader wants to buy 1 lot of EURUSD, which is worth $100 000, with 1:100 leverage.
M = $100 000 / 100 = $1000
Meaning a trader needs to have $1000 of the free margin.
Forex margin requirement will depend on the leverage ratio the trader chooses, the lot size, and the instrument. Let us show you examples of the FBS leverage and margin required to use it:
Leverage | Margin Requirement | Margin requirement for one EURUSD lot (or €100 000) |
1:50 | 2% | $2000.00 |
1:100 | 1% | $1000.00 |
1:200 | 0.5% | $500.00 |
1:500 | 0.2% | $200.00 |
1:1000 | 0.01% | $10.00 |
1:2000 | 0.05% | $5.00 |
1:3000 | 0.03333333% or 1/30% | $3.3333333 or $3 1/30 |
Risks of Trading with Leverage
The real leverage can potentially enlarge your profits or losses by the same magnitude. The greater the leverage, the higher the risk trader assumes.
Let's illustrate this point with an example. Trader A and Trader B have a trading capital of $1000. After some analysis, both agree that EURUSD found the bottom and should go up. Therefore, both buy the EURUSD at 1.00000.
Trader A chooses 1:100 leverage on this trade by buying $100 000 (1 lot) of USD (100 x $1000). At the same time, Trader B chooses 1:10 leverage on this trade by buying $10 000 (0.1 lot) worth of EURUSD (10 x $1000).
The point value for EURUSD is worth 1$.
If EURUSD declines to 0.99500, the price is down by 500 points. In this case, Trader A loses:500 points x $1 x 1 lots = $500 or 50% of the capital.
At the same time, Trader B will lose:
500 points x $1 x 0.1 lot = $50 or 5% of the capital.
This table shows how the trading accounts of these two traders compare after the 500-point loss.
Trader A | Trader B | |
Trading Capital | $1000 | $1000 |
Real Leverage Used | 1:100 | 1:10 |
Total Value of Transaction | $100 000 | $10 000 |
In the Case of a 500-point Loss | $500 | $50 |
% Loss of Trading Capital | 50% | 5% |
% of Trading Capital Remaining | 50% | 95% |
This example also highlights the importance of risk management as using 100% of your trading capital as a margin for single trade increases the risk of a loss.
Pros and Cons of Leveraged Trading
Pros of Trading with Leverage
Capital Boost. Leverage boosts the capital available to invest in various markets. For instance, with a 100:1 leverage, you effectively have control of $100 000 in trading capital with only $1000, meaning you can allocate meaningful amounts to various trade positions in your portfolio.
Interest-Free Loan. Leverage is a loan provided by your broker to allow you to take a bigger position in the market. However, this ‘loan’ doesn’t come with any obligations in the form of interest or commission, and you can use it in any manner you wish when trading.
Mitigating Against Low Volatility. Market price changes usually occur in high and low volatility cycles, meaning that periods of low volatility can be particularly frustrating for traders because of the tiny price action. Thankfully, with trading with leverage, traders can potentially bank bigger profits even during these moments of low volatility.
Trading Premium Markets. Leverage makes it possible for average retail traders to trade some expensive instruments, which traders can't afford when using their own capital.
Cons of Trading with Leverage
Amplified Losses. The biggest risk when trading with leverage is that it amplifies losses when the market goes against you. Leverage may require minimal capital outlay, but losses can be substantial because trading results are based on the total position size you are controlling.
Margin Call Risk. ‘Margin Call’ occurs when floating losses surpass your used margin. Because leverage amplifies losses, there will always be an ever-present ‘margin call’ risk when you have open trading positions in the fast and dynamic financial markets.
Which Markets Can You Trade Using Leverage?
Forex Trading with Leverage
Forex trading involves buying and selling foreign currencies across the global market. Forex leverage ratios start relatively high compared to other markets at around 50:1, meaning that there is an increased opportunity for profit or loss, depending on how you look at it.
Forex traders monitor the currency movements in points, which is the slightest change in currency price. These movements are just fractions of a cent. For example, when a currency pair like the GBPUSD moves 1000 points from 1.95000 to 1.96000, just a 1-cent move in the exchange rate.
Therefore, currency transactions must be carried out in sizable amounts, allowing these minute price movements to be translated into larger profits. That’s why on Forex market trading results are magnified through leverage. When you deal with an amount such as $100 000, small changes in the price of the currency can result in significant profits or losses.
Stocks and indices (CFDs) with Leverage
A contract for difference (CFD) is a contract between a buyer and a seller that stipulates that the buyer must pay the seller the difference between the current value of an asset and its value at contract time. CFDs allow traders and investors to profit from price movement without owning the underlying assets, meaning a trader won’t get dividends for a stock you’ve bought. The value of a CFD contract doesn’t consider the asset's underlying value: only the price change between the trade entry and exit. Moreover, the best fact about CFDs is that this instrument provides higher leverage than traditional trading.
Commodities with Leverage
Using leverage is much more common with commodity trading than with stock trading. Commodities tend to be short-term investments, in contrast to stocks and other market assets where buying and holding for long term is more common.
In addition, you have more time to make trades with commodities because markets are open 24/5. With stocks, you primarily make trades during regular business hours, when the stock exchanges are available.
Overall, commodity trading is considered of higher risk and more speculative than stock trading, but it can also lead to larger gains.
Questions about Leverage in Trading
Is Trading with Leverage Safe?
While leverage may increase returns, there’s a drawback: if the trade doesn’t work out, it may increase the potential risk and loss of the investment.
Is Trading with Leverage Worth It?
Trading with leverage can be effective because it lets investors with less cash increase their trading power, increasing their returns from successful investments.
Which instruments are allowed to trade with leverage?
With FBS, you can trade currencies, metals, energies, stocks, indices, and even cryptocurrencies with leverage. The highest allowed leverage depends on the account type and trading instrument.
Is Trading with Leverage Halal in Islam?
Yes, trading with leverage is halal in Islam. Leverage is nothing more than employing debt to buy a security or implement an investment strategy. That said, the investment for which a trader uses the trading platform's leverage must comply with Shariah. Overall, trading with leverage is perfectly acceptable in Islam.
Conclusion
There's no need to be afraid of leverage once you have learned how to manage it. Anyone can use leverage successfully and profitably by following proper management. Like any sharp instrument, leverage must be handled carefully — once you learn to do this, you have no reason to worry.
Smaller amounts of real leverage applied to each trade allows a trader to have more breathing room by setting a wider but reasonable Stop Loss order and avoiding a higher capital loss. A highly leveraged trade can quickly finish your trading account if it goes against you, as you will rack up more significant losses due to the bigger lot sizes. Remember that leverage is flexible and customizable to each trader's needs.
