Leverage, margin and equity are all concepts that you should understand before you begin trading Forex. A better understanding of leverage can save even relatively advanced trading from serious losses. In this article, I’ll explain what leverage and margin are, how you calculate them, and how much leverage you should use when trading Forex.
What is Leverage?
Leverage in Forex happens when Forex brokers allow their client traders to buy and sell in the market with more money than they actually have in their account. Forex brokers offering leverage effectively loan money to their trading clients who want to be “leveraged”. Almost all Forex brokers offer leveraged trading, and the maximum leverage which can be offered by a Forex broker is limited by law and regulation in the country from which they are operating.
Leverage allows traders to control much more money in the Forex market than they actually own.
An example of leverage in Forex: a trader deposits $100 with a Forex broker and opens a trade in the USD/JPY currency pair with a position size of 1 micro-lot (equal to 0.01 lots). As 1 lot of USD/JPY is worth $100,000 a micro-lot is worth $1,000. The trader has deposited $100 but controls $1,000, so the trader is leveraged at a rate of 10 to 1 – this is called the trader’s “true leverage”. The Forex broker allows the trader to do this because the broker allows a maximum rate of leverage on USD/JPY trades which is equal to or higher than 10 to 1.
The use of leverage in Forex or any type of investment or speculation is possible because it is extremely unlikely that the value of an asset, especially a major currency, will collapse to zero very quickly. So, brokers will not fear allowing traders to control more money than they actually have, up to a limit.
The maximum leverage regulators and brokers allow varies according to the anticipated volatility of what is being traded. For example, Bitcoin has a recent history of making very dramatic price movements, so many brokers apply a maximum leverage in Bitcoin of only 2 to 1, meaning traders must deposit at least half of the amount they want to control in the market. At the other extreme, the EUR/USD currency pair tends to fluctuate by approximately only 10% in value over a year, so the maximum leverage available there is usually 30 to 1 or even higher.
What is Margin?
Margin is the minimum amount of money that a Forex broker requires a trader to have in their account to open and maintain a trade. It is expressed as a percentage of the trade size.
For example, if a Forex broker offers a maximum leverage of 30 to 1 on trading the USD/JPY currency pair, and you want to open a trade of 1 lot of USD/JPY which is worth $100,000, then the broker will require that you have at least $3,333.34 in your account to open the trade – in other words, 3.33% of the position size.
A broker offering maximum leverage of 30 to 1 requires a margin deposit of 3.34%.
It is easy to see why margin and leverage can always be calculated from each other by a simple formula. If you know one, you can determine the other.
A Forex margin calculator will tell you that margin = 1/leverage (where leverage is the X in the X to 1 leverage expression).
A Forex leverage calculator will tell you that leverage = 1/margin (where margin is expressed as a percentage).
These are simple calculations which you can do yourself, most people find they don’t really need to use the calculators.
The table below shows how leverage and margin relate to each other at benchmark rates. Note how the margin required as a percentage is also the price movement which would wipe out an account leveraged at that level.
What is Equity?
The equity in a trading account is its cash value if all open trades were closed immediately.
Equity = cash in account + floating profits of open trades – floating losses of open trades.
The main uses of equity are that it shows how much your account is really worth right now, and how much you should risk on your next trade if you are sizing your trades based upon a fraction of account equity. This position sizing strategy is arguably the most robust form of money management which a Forex trader can use.
What is Free Margin?
Free margin is the cash value of what you have available to use as margin for opening any new trades.
Free margin = equity – margin of open trades.
What is a Margin Call?
A margin call will happen when your equity is no longer larger than the margin required by your broker to support all your open trades. “Margin call” in an old-fashioned term – in modern Forex trading, your broker will simply close enough of your open trades to make sure that your equity is at least as big as the required margin on the remaining trades which stay open. Forex brokers have written policies on how they do this so if you are interested, you can ask your broker how they operate a margin call.
How Much Leverage Should I Use in Forex Trading?
As major currencies’ prices tend to fluctuate much less in value than stocks and commodities, it is easy to get high leverage in Forex trading. Even conservative regulators and brokers will allow leverage of at least 30 to 1 on major Forex pairs, and it possible to find brokers in some countries that will go as high as 1,000 to 1. It can be very tempting to use high leverage due to the possibility of making very high profits, but this can work both ways and produce very high losses instead.
The Risk of Leverage in Forex Trading
It is important to remember that if you use any leverage, your account can be completely wiped out if there is a large enough price movement against you. Hard stop losses mitigate this risk, but in very volatile markets there can be significant slippage on stop orders, which makes high leverage extremely risky.
During the Swiss Franc flash crash of 2015, the Swiss Franc in an instant rose in value against every other currency by more than 20%. Excepting the few brokers offering guaranteed stop losses, stop losses were not triggered, and it became impossible to close any open trade in the Swiss Franc or to open a new trade in it at every Forex broker for about an hour. This meant that anyone who was short of the Swiss Franc using a leverage of more than 5 to 1 during this incident lost their entire Forex account. In fact, it was common in 2015 for Forex brokers to hold their customers liable for losses beyond their deposits, so some traders were pursued legally for large, life-changing legal debts. Luckily, new regulations and better practices have made sure that most brokers cannot or will not hold their clients liable for losses beyond their deposits.
Leverage Should be Appropriate for Volatility
How much leverage you should use can be effectively determined by what it is you are trading. If you are trading very liquid, major currencies such as the U.S. Dollar, Euro, and Japanese Yen, it might make sense to use higher leverage. If you are trading pegged, manipulated or minor currencies (all of which applied to the Swiss Franc in 2015), it would make sense to be much more cautious and use lower leverage or ideally no leverage at all.
How to Engineer Leverage from Maximum Drawdown
One way to determine how much leverage you should use is to decide that you will risk a certain percentage of your account equity on each trade. You then size the trade so that the distance from your entry price to your hard stop loss equals that amount.
The question of what percentage of your account to risk on a single trade is determined by two factors:
- How many losing trades do you think you might have in a row in a worst-case scenario; and
- What is the maximum drawdown (percentage loss from an equity peak) you are prepared to suffer?
For example, say you have a $1,000 Forex trading account. You decide that you are not prepared to tolerate a drawdown bigger than 20% and that your worst-case losing streak will be no more than 20 trades in a row. The precise calculation is more complex, but it is obvious that according to these parameters you should not risk more than 1% of your account equity per trade. At the start this would be $10 which you just divide by the number of pips from entry to the stop loss, which will give you the dollar per pip position size. Unless you are using extremely tight stop losses, the result will probably see you trading with a leverage of no more than 5 to 1, if stop losses are usually about 20 pips. This is much less than the maximum Forex leverage typically offered by brokers. From this, it becomes easier to understand why trading with high leverage is risky.
You must understand that drawdowns in your account need to be taken seriously, because after you suffer losses, you need to make a larger percentage increase in your remaining equity just to get back to where you were at before the loss. This table shows how big an increase is required to recover from losses of a certain size.
The data shows that once you suffer a drawdown greater than 20%, your position worsens exponentially.
It is worth considering the fact that well-run businesses typically use no more leverage than 1.3 to 1. I am very reluctant to use leverage greater than 3 to 1 in Forex trading.
High Leverage Forex Trading
If you are determined to trade Forex with high leverage, there are some things you should do to minimize your risk:
- Try to develop and use a trading strategy which has a high win rate but also relatively large stop losses. This will help you get the best compounding effect and minimize drawdown, but at the cost of some overall profitability.
- Trade only the most liquid currencies such as the USD, the EUR, and the JPY. Do not trade very risky assets such as cryptocurrencies, individual stocks, or exotic currencies (you probably won’t be able to get high leverage on these assets anyway).
- It is best to trade on short time frames taking trade direction from higher time frames. This way you can keep losses to a minimum.
- Be sure to trade with a Forex broker offering negative balance protection, so you cannot be held legally liable for an amount beyond what you deposit with the broker.
High Leverage Forex Brokers
I don’t recommend trading Forex with high leverage. Even in the most tightly regulated countries of the European Union, leverage of 30 to 1 is still available on major Forex pairs at almost every Forex broker, and that is relatively high.
As a general rule, the countries with lighter Forex regulation are where you will find Forex brokers offering much higher maximum leverage than the 30 to 1 available from Forex brokers in the European Union or the 50 to 1 available from Forex brokers in the U.S.A.
High leverage Forex traders might consider using one of the many Australian Forex brokers. Australia offers a possibly unique balance between a serious level of regulation and a high maximum leverage. ASIC regulation allows leverage on Forex pairs as high as 500 to 1.
How to Calculate Pip Values
In a majority of currencies, a pip equals .01% of the currency, so 10,000 pips = 1 unit. To make things a little more concrete, let's examine the U.S. Dollar when it comes to pip value. 100 pips = 1 cent and 10,000 pips equal $1. This is the equation in most cases, but a well-known exception is the Japanese Yen. The Yen is worth relatively so little, that each pip is not worth a ten thousandth of a unit but rather each pip is 1% of a Yen.
When you are trading one currency against another, the value of the pip is in the quoted price not the base price. So, for example, if the position is EUR/USD, the pip value is in U.S. Dollars (.0001 USD). However, for USD/EUR, the pip value is .0001 EUR. If the conversion rate from Euros to Dollars is 1.35, then 1 Euro pip equals 0.000135 dollars.
Since most calculations in forex are displayed in pips, in order to understand your gains or losses, you will need to convert your pips to your currency. Let's take the USD for example. If you close a trade, to determine your total loss or gain, you must first multiply the pip difference by the number of units traded. This will give you the total pip difference between the opening and closing of the trade. If the quoted price is USD then the pips are expressed in USD, but if the USD is the base currency, you will need to convert the pip value to USD.
Converting the pip value to USD is a pretty simple equation. You just take total pip profit or loss and divide it by the conversion rate.