All traders need to have an understanding of Forex Leverage so that they are able to work out how much currency they can trade at any one time, while still obeying sound money management rules. The concept was introduced briefly in our Forex for beginners guide, but here we will go into more detail and provide some real world examples.
What is Leverage in Forex?
In the lesson about Forex pips we learned that individual pips are generally of very low value. In order to take advantage of the pips we make as traders it is necessary to buy and sell large amounts of currency – a standard Forex lot of USD for example is $100,000. Most traders do not have this kind of money to trade with, so they use the power of leverage to help them out. Forex Leverage basically allows a trader to open a position for an amount greater than the total margin they have in their account. Margin is just a name for the available trading funds which have been deposited. Here is how it works . . .
If you are going to use $5000 of your account margin and you wish to open a position which is $100,000 in size, your account leverage is 20:1. This is because your position size is 20 times that of your margin. If the trader uses only $2000 margin then to open the same $100,000 position would require Forex trading leverage of 50:1, pretty simple so far.
Ok, so if you are only putting up a small percentage of the funds required open these large positions, where does the rest come from? Well, it comes from your broker. One of the roles of a broker is to facilitate Forex leverage by lending traders the additional funds they need to make a trade. If you are contributing only $2000 or $5000 of a $100,000 position, the other $98,000 or $95,000 is loaned to you by your FX broker. The trader themselves is always required to contribute at least a small amount of the position size, kind of like a deposit.
The amount of FX leverage you are allowed to use with your account will let you know how much you need to contribute to your position sizes. For example . . .
10:1 = 10% contribution
20:1 = 5% contribution
50:1 = 2% contribution
100:1 = 1% contribution
It is worth mentioning here that with Forex trading you do not have to use all of your available funds to make up the margin requirement when opening a position. So, if you have $10,000 in your account and you want to open a $200,000 position, if your account allows 100:1 leverage then you will only need to contribute $2000, which is 1% of your position size. Even though you are only offering up a small portion of the sum you are trading yourself, when the trade is live, the full amount gained or lost in pips will affect your account. So in this example you would have a pip value of $20, winning 10 pips would net you $200, whereas losing 10 pips would result in $200 being deducted from your account balance.
Leverage Forex Trading in Practice
By this point you will hopefully have an understanding of Forex leverage and what it means for you in terms of margin and position sizes. In the rest of this lesson we are going to learn to trade Forex using an example scenario which takes advantage of leverage. This should allow you to calculate profit/loss using our knowledge of pip values, lots and leverage together.
We have an account size of $10,000 and no open trades, so our full $10,000 is available as margin. The maximum leverage allowed for this particular account is 50:1, so we must contribute at least 2% of the value of any positions we open. We decide to take a USD/CAD long trade – buying US Dollars and selling Canadian Dollars.
Our broker (in this case IBFX) is quoting us a bid price of 1.0095 and an offer price of 1.0098. As buyers we will be paying the offer. We open a long position of half a standard lot, or five mini lots which is $50,000 at the price of 1.0098. With a limit of 50:1 Forex leverage we must put up $1000 of our margin towards the $50,000 total, with the remaining $49,000 being loaned to us by our broker. If you are unsure about quote reading and bid/offer prices, see our Forex trading basics lesson.
After about half and hour price has risen to 1.0123 and is showing signs of a reversal. Here we take profit and close out the position. The quote from out broker as we close out has a bid price of 1.0123 and an offer of 1.0126. We are now selling to cancel out the buy we made earlier when initiating the trade, we sell at the bid of 1.0123.
In summary, we have bought USD/CAD at 1.0098 and then sold at 1.0123. The different between these two prices is 0.0025 which equals 25 pips.
So using Forex leverage, how much profit have we made for our account from the 25 pips we netted in this trade?
We use the offer price (the price at which we bought) to calculate pip value. To do this we divide one pip (0.0001) by the offer which was 1.0098 and then multiply by our lot size of 50,000 (we used half a standard lot, or one mini lot).
0.0001/1.0098 * 50,000 = $5.049 pip value.
$5.049 * 25 pips = $126.22 trading profit
Overall we have added a profit of $126.22 to our total account balance of $10,000.
Ok, so hopefully this will answer many beginning traders’ questions such as ‘what is Forex leverage trading?’ The examples in this lesson will enable you to complete your own Forex leverage calculations so you can see how account size, margin, pips and lot sizes are all related.
Feel free to use the comments sections below if you are still unsure about any of the topics covered here or anything else you come across as you learn Forex trading on the internet.
