How Leverage Affects the Forex Market
More than $5 trillion worth of currency exchanges occur daily on the forex market, the largest in the world. A forex trader buys and sells currency exchange rates with the goal of increasing the exchange rate. The forex currency rate is displayed with the broker as bids and offers. The bid price is what an investor receives when they want to buy a currency, and the ask price is what they receive when they want to sell the currency.
As an example, an investor may bet he will be able to make money by buying the euro against the dollar (EUR/USD). A trader would buy the EUR/USD at the ask price of $1.10. Should the rate go in favor, the trader would unwind the position by selling the EUR/USD back to the broker at the bid price a few hours later. Depending on which exchange rate was used to buy or sell, the trader would make a gain (or a loss).
Leverage is used by investors to increase profits from forex trading. Foreign exchange provides investors with the highest amount of leverage available. In essence, leverage is a loan provided by the broker to the investor. Trades on margin or borrowed funds can be executed on a trader's forex account. Some brokers will restrict the amount of leverage a new trader can use in the beginning. In most cases, traders can choose how much or how big of a trade they want based on their desired leverage. The broker will require a certain percentage of the trade's notional amount to be held in the account as cash, known as the initial margin.
Various Forex Leverage Ratios
Depending on the size of the trade, brokers may require a different initial margin. Investors buying EUR/USD worth $100,000 might need to hold $1,000 in margin. To put it another way, the margin requirement would be 1% or ($1,000 / $100,000).
Leverage ratio indicates how much the trade size is magnified as a consequence of the broker holding margin. According to the initial margin example above, the leverage ratio for the trade would be 100:1 ($100,000 / $1,000). An investor can, for example, trade $100,000 in a currency pair by depositing $1,000.
The following examples illustrate margin requirements and leverage ratios.
Margin Requirements and Leverage Ratios
The equivalent leverage ratio as a result of the margin requirement.
In the table above, we can see that the lower the margin requirement, the higher the leverage that can be used for each trade. In some cases, a broker may require higher margin requirements, depending on the currency being traded. In the case of the British pound versus the Japanese yen, for example, the rate can fluctuate wildly, causing big swings in the rate. If you trade more volatile currencies or during volatile periods, the broker may ask you to hold more collateral (e.g. 5%).
Leverage and trade size: How to use them
Margin requirements can vary between larger and smaller trades, depending on the broker. Based on the above table, the trader must place a minimum of 1/100, or 1%, of the total value of the trade as collateral in the trading account. For a trade of this size, the leverage might be 50:1 or 100:1 for a trade of 100,000 units of currency. When the position is $50,000 or less, a higher leverage ratio, like 200:1, is used. Brokers often allow investors to execute smaller trades, for example, $10,000 to $50,000, with a smaller margin. The leverage of 200:1 is unlikely to be available to a new account. In most cases, a broker will grant 50:1 leverage on a $50,000 transaction. The margin requirement for a trader using a leverage ratio of 50:1 is 1/50 = 2%. This means there is a $1,000 collateral requirement for every $50,000 trade. It should be noted that margin requirements are subject to fluctuation, depending on the leverage used for that currency and what the broker requires. In the case of emerging market currencies such as the Mexican peso, some brokers require a margin of 10-15%. Despite the increased collateral, the leverage permitted might only be 20:1. Traders' margin requirements can be increased or leverage ratios reduced as brokers manage their risk.
As a rule, forex leverage tends to be much higher than the 2:1 leverage commonly used in equity markets and the 15:1 leverage commonly used in futures markets. Despite the fact that 100:1 leverage may seem extremely risky, the risk is significantly less when you consider that the price of currency changes by less than 1% during intraday trading (trading within one day). Currency fluctuations would make brokers unable to provide the same level of leverage as equities.
Leverage carries risks
Leverage can lead to substantial profits for investors, but it can also work against them. When the currency underlying one of your trades moves in the opposite direction of what you expected, leverage greatly increases the potential losses. Traders usually implement a strict trading strategy, which includes stop-loss orders to control potential losses in order to avoid a catastrophe. Stop-loss orders are orders to exit a position at a certain price with a broker. Traders can use this method to cap their losses on a trade.
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