Forex Leverage: How Leverage Works in Forex, and, Is It Your Friend?
Leverage enables the traders to trade bigger amount of money by having a small amount of money in their accounts. Forex leverage has always been a controversial topic. The main question is whether it is more to help the traders, or it is mainly used as an advertising tool by Forex brokers to attract more customers, and then a good way to make the accounts become wiped out faster.
Before talking about Forex leverage and how it works, and whether it is your friend or not, I explain what it is by giving you some simple examples.
What Is Forex Leverage?
Forex leverage is just a broker side setting that enables the traders to take bigger positions with a small amount of money in their accounts. It is the broker who can set your account leverage. You can’t modify it on your own.
Let’s say you have a USD live trading account with a broker. When the leverage is 1:1, then one dollar of your account works exactly as one dollar. Therefore, when EUR/USD rate is for example 1.2400, then you will have to pay $1.24 to buy one EUR against USD or to buy one EUR/USD.
When your account leverage is 1:2, it means each dollar of your account works as two dollars. Therefore, when EUR/USD rate is 1.2400, then to buy one EUR against USD, you have to pay $0.62:
$1.24 / 2 = $0.62
What if is your account leverage is 1:100?
Then each dollar of your account balance works as $100. Therefore, to buy one EUR against USD or one EUR/USD while the rate is 1.2400, you have to pay $0.0124:
$1.24 / 100 = $0.0124
That is how Forex leverage works.
Is Forex Leverage a Facility for Traders or a Tool for Forex Brokers?
At the first glance, leverage looks like a nice feature and facility that brokers freely and handsomely offer to their clients. What is better than trading $1000 or $2000 by having $1 or $0.50 in your account? It looks like a nice feature that is offered for free.
I see that nowadays some Forex brokers offer even 1:1000 and 1:2000 leverage and accept the minimum deposit of as low as $100 to open an account.
There is no doubt that these brokers don’t do this to help the poor Forex traders who cannot afford to open a big enough and reasonable live account. But the fact is 99.99% or I’d better to say 100% of those who open a $100 account with such a high leverage, will wipe out their accounts very easily. This is what brokers know better than anybody else.
Some of them even offer cash rewards if you open an account with them. For example they add $50 to your account if you open a $100 account with them. The reason is that they do know that your $100 will be in their pocket, and the $50 they add to your account will never have to be paid to you, because you will never withdraw any money.
So, leverage is mainly a decoy to attract more retail traders who cannot afford to open big accounts. Professional Forex traders don’t care about the leverage, because they calculate their position size carefully and precisely. They don’t take more than a 2-3% risk per each trade setup. Therefore, leverage has no importance for them.
Forex Leverage Has Nothing to Do with Risk/Reward
It is recommended to take no more than a 2-3% risk per each trade setup. It means you have to choose the position size in a way that if it gets hit, you lose 2-3% of your capital. For example, when you have a $10,000 account and you have located a trade setup, you should choose the position size in a way that if you get stopped out, you lose $200 which is 2% of your account.
Unlike what most novice traders think, calculating of your position size has nothing to do with leverage. It depends on (1) the currency pairs and their pip value; (2) stop loss size; and, (3) the risk you want to take.
Also, leverage has nothing to do with pip value and the profit you will make. You can only make more profit by taking larger positions which is what a higher leverage helps you to do. But it can also cause you to lose more. That is why they say Forex leverage is a double edged sword.
Leverage is related to the required margin. When your account has a greater leverage, you will need smaller required margin. You can refer to the above example again. When your account leverage is 1:1, then you need a $1.24 required margin when you want to buy one EUR against USD while the EUR/USD rate is 1.2400. But when your account leverage is 1:100, then you will need $0.0124 required margin which is 100 times smaller.
Therefore, leverage enables you to take bigger positions with a smaller amount of money. But you can wipe out your account a lot faster and easier too. For example, when the price has to go against you for 100 pips to wipe out your account when you account leverage is 1:100, it can do it only by going against you for 20 pips to wipe out your account, when your account leverage is 1:500.
It means when a trader opens a $100 account with 1:500 leverage, then he will blow up the account sometimes with the first position he takes. It means Forex brokers don’t care about you and your money. They care about making more money out of your losses:
Forex Leverage Is Not Your Friend
So, leverage is not the friend of the novice traders who don’t know how Forex trading works. If you are new to Forex trading, then I recommend you to read this article carefully: How Does Forex Work and Does It Really Work?
As I mentioned earlier in this article, professional Forex traders don’t care about leverage, because it has nothing to do with their calculations. Many of them even trade through the bank accounts that are not usually leveraged:
Leverage has another risk too. You can lose your account by the strong and sudden market movements (e.g. The Swiss Franc Tsunami), only when your account is leveraged. When there is no leverage, you can lose money when the market goes against you for 1000s of pips, but your account won’t get blown up. It is the leverage that wipes out your account. It can even cause you to have negative balance when strong and sudden market movements occur. But negative balance can never happen when there is no leverage.
In general, if you want to make money through Forex trading, you’d better to complete your knowledge and experience first. Forex leverage cannot make your a millionaire, nor can you turn a $100 account into thousands with a high leverage. Forex trading is not usually what most people think, and it doesn’t work the way that most people want to make it work. I recommend you to read this article too: Trading Strategies Don’t Work If You Don’t Choose the Right Living Strategy