How leverage is used in forex trading

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How leverage is used in forex trading

Leverage is commonly employed in global markets to buy not just physical assets such as real estate or vehicles, but also financial assets such as shares and foreign currency or forex.

Retail forex trading has increased dramatically in recent years, owing to the spread of internet trading platforms and the availability of low-cost borrowing. Leverage in trading is sometimes compared to a two-edged sword since it multiplies both profits and losses. This is especially true in forex trading, where huge levels of leverage are the standard. The following examples show how leverage multiplies returns for both successful and bad investments.

Examples of Forex Leverage

Assume you are an investor in the United States with an account with an online FX broker. Your broker offers the highest leverage permitted in the United States on major currency pairings of 50:1, which means you may trade $50 of a major currency for every dollar you put up. You put up $5,000 in margin, which is your trading account’s collateral or equity. This means you may initially invest up to $250,000 ($5,000 x 50) in forex trading positions. This sum will undoubtedly change based on your income or losses (note: this and the examples below are gross of commissions, interest, and other charges).

Example 1: Long USD / Short Euro. Trade amount = EUR 100,000

Assume you started the above trade when the exchange rate was EUR 1 = USD 1.3600 (EUR/USD = 1.36), because you are negative on the Euro and anticipate it to fall in the near future.

Leverage: In this transaction, your leverage is somewhat more than 27:1 (USD 136,000 / USD 5,000 = 27.2).

Because the euro is quoted to four decimal places, each “pip” or basis point shift in the euro is equivalent to one-hundredth of one percent, or 0.01%, of the amount traded in the base currency. Because USD is the counter currency or quotation currency, the value of each pip is stated in USD. In this scenario, each pip is worth $10 depending on the currency amount transacted of €100,000. (If €1 million was traded against the USD, each pip would be worth $100.)

Stop-loss: Because you are new to forex trading, you set a tight stop-loss of 50 pips on your long USD / short EUR trade. This indicates that your maximum loss if the stop-loss is activated is $500.

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Profit / Loss: Fortunately, you have beginner’s luck, and the euro falls to EUR 1 = USD 1.3400 within a few days after starting the deal. You finish the trade with a profit of 200 pips (1.3600 – 1.3400), or USD 2,000. (200 pips x USD 10 per pip).

In traditional words, you sold short €100,000 and got $136,000 in your first transaction. When the deal was finished, you purchased back the euros you had shorted at a lower rate of 1.3400, paying $134,000 for €100,000. The $2,000 difference indicates your gross profit.

Leverage’s Effect: Using leverage, you were able to create a 40% return on your $5,000 original investment. What if you had just traded the $5,000 with no leverage? In that situation, you would have merely been short $5,000, or €3,676.47 (USD 5,000 / 1.3600). Because the quantity of this transaction is so little, each pip is only worth USD 0.36764. Closing the short euro trade at 1.3400 would have resulted in a USD 73.53 profit (200 pips x USD 0.36764 per pip).Leverage increased your returns by 27.2 times (USD 2,000 / USD 73.53), or the amount of leverage employed in the deal.

Example 2: Short USD / Long Japanese Yen. Trade amount = USD 200,000

Your 40% profit on your first leveraged forex transaction has piqued your interest in doing additional trading. You shift your focus to the Japanese yen (JPY), which is now trading at 85 to the USD (USD/JPY = 85). You anticipate that the yen would increase against the USD, therefore you open a USD 200,000 short USD / long yen trade. Because you now have USD 7,000 in margin in your account, the success of your initial transaction has made you want to trade for a greater sum. While this is far greater than your initial deal, you take comfort in the knowledge that you are still well under the USD 350,000 maximum you could trade (based on 50:1 leverage). Leverage: For this deal, your leverage ratio is 28.57 (USD 200,000 / USD 7,000).

Pip Value: Because the yen is quoted to two decimal places, each pip in this deal is worth 1% of the base currency value represented in quote currency, or 2,000 yen.

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Stop-loss: You set a stop-loss level of JPY 87 to the USD on this trade since the yen is highly volatile and you do not want your position to be stopped out by random noise.

Remember, you’re long yen and short USD, therefore you’d want the yen to strengthen against the USD so you can close out your short USD position with less yen and pocket the difference. However, if your stop-loss is activated, your loss will be significant: JPY 400,000 / 87 = USD 4,597.70 for 200 pips at 2,000 yen each pip.

Profit / Loss: Unfortunately, news of the Japanese government’s new stimulus package causes the yen to quickly drop, and your stop-loss is triggered a day after you enter the long JPY trade. As previously stated, your loss in this scenario is USD 4,597.70.

Forex Math: In traditional words, the math is as follows:

Short USD 200,000 @ USD 1 = JPY 85, i.e. + JPY 17 million as an initial position

Closing position: When the stop-loss is triggered, the USD 200,000 short position is covered at USD 1 = JPY 87, i.e. – JPY 17.4 million.

The difference of JPY 400,000 represents your net loss, which comes out to USD 4,597.70 at an exchange rate of 87.

Leverage’s Effect: In this case, applying leverage amplified your loss, which amounts to about 65.7% of your total margin of USD 7,000. What if you had simply shorted USD 7,000 vs the yen (at USD1 = JPY 85) with no leverage? Because this transaction is less in size, each pip is only worth JPY 70. The stop-loss at 87 would have resulted in a JPY 14,000 loss (200 pips x JPY 70 per pip).Leverage multiplied your loss by 28.57 times (JPY 400,000 / JPY 14,000), or the amount of leverage employed in the deal.

Tips When Using Leverage in Forex Trading

While the possibility of making large gains without putting up much of your own money may be appealing, bear in mind that using too much leverage might result in you losing your shirt and much more. Professional traders utilize a few safety steps that may assist lessen the inherent hazards of leveraged FX trading:

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  • Limit Your Losses. If you want to make a lot of money, you must first understand how to minimize your losses. Limit your losses to realistic levels before they spiral out of control and significantly damage your value.
  • Make use of Strategic Stops. Strategic stops are critical in the 24-hour forex market, where you might go to bed and wake up the following day to find that your position has been negatively impacted by a few hundred pips. Stops may be used not just to limit losses, but also to safeguard earnings.
  • Don’t go too far ahead of yourself. Do not attempt to exit a losing situation by doubling down or averaging down. The most significant trading losses have happened as a result of a rogue trader sticking to his guns and adding to a losing position until it became so huge that it had to be liquidated at a catastrophic loss. The trader’s assessment may have been correct in the end, but it was often too late to save the situation. It’s much better to reduce your losses and keep your account alive to trade another day than to wait for an improbable miracle to reverse a massive loss.
  • Use Leverage Appropriate to Your Level of Comfort. A 50:1 leverage indicates that a 2% negative move might wipe out all of your equity or margin. If you are a conservative investor or trader, select a lesser degree of leverage that is suitable for you, such as 5:1 or 10:1.

The Bottom Line

While the high level of leverage inherent in forex trading multiplies returns and dangers, our examples show that by following a few measures utilized by skilled traders, you may help limit these risks and increase your chances of boosting gains. See “ForexLeverage: A Double-Edged Sword” for further information on forex leverage.

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