Forex leverage explained

One of the main reasons why so many people are attracted to forex trading compared to other financial instruments is that with forex you can get much higher leverage than with stocks and futures trading.Put simply leverage means using a small amount of money to trade positions which are worth much more. In forex, leverage is a loan provided by the forex broker to the forex retail trader.

The amount of leverage offered by forex brokers have generally varied from 50:1 to 400:1.For example,if the broker requires a margin of 2%, this means that you have to deposit only $200 to trade $10,000 worth of currencies. As you can see here, forex margin and forex leverage are strongly linked to each other so much so that in this example you would leverage your margin to trade a much larger value of currencies. This is what the notion of margin-based leverage means.

In the forex market we monitor currency movements in pips, which is the smallest change in currency prices. For example, when a currency pair like the USD/CHF moves 100 pips from 1.1200 to 1.1300, this represents only a $0.01 move in the USD/CHF exchange rate. This is the reason why foreign currency trading should be done with large amounts of money to allow the small fluctuations in prices to translate into tangible profits or losses. However, unlike big banks most people do not have large sums of money to trade foreign exchange. This is argued to be the main reason why there is high leverage in the forex market.

Though you can use leverage to make substantial profits,this tool can be equally dangerous . Let us now take an example to see why and how this occurs. We assume that there are two forex traders Y and Z and each has $5000 as trading capital. They also trade with the same forex broker who requires 1% margin deposit.After applying some technical indicators on the USD/CHF chart, both agree that it will fall in value over the next few days, and thus both decide to sell the pair at 1.1200.

Trader Y chooses to apply 100 times real leverage on this trade by shorting $500,000 worth of USD/CHF (100 x $5,000) based on his $5,000 trading capital.In terms of the value of one pip for the five standard lots bought by trader Y this equals to around $44.60, given that the market price is at 1.1200.Unfortunately the price of the USD/CHF rises to 1.1300 and Y loses 100 pips. This loss equals to approximately $4,460 and represents 89.2% of his $5,000!

Trader Z who is far less adventurous decides to apply 5 times real leverage on his trading capital, and so sells only $25,000 of USD/CHF (5 x $5,000).This $25,000 worth of USD/CHF equals to just one-quarter of 1 standard lot. When USD/CHF increases to 1.1300, that is, by 100 pips, Trader Z loses $223. This loss represents a relatively lower 4.46% of his trading account.

It is important to point out the difference between real leverage and margin-based leverage .As we have seen in this example Trader Z has used real leverage of 5 times whereas Y has used 100 times maximum real leverage.In terms of margin-based leverage the broker allowed both traders to trade up to a maximum leverage of 100:1. Given that the broker requires 1% margin, Y has leveraged his margin of $1,000 to $100,000 for each standard lot. This also means that he has used a real leverage of 100 which is obtained by taking $500,000 divided by $5,000. And so if he had bought only $100,000 he would have used only 20 times real leverage and lost less money. It is real leverage which is dangerous.

The explanation above should now give you a clearer picture why the CFTC has decided to reduce leverage to 50:1 for major currency pairs such as the USD/CHF. If broker X is forced to increase his margin from 1% to 2% (decrease his leverage from 100:1 to 50:1), this means that our Trader Y would also be forced to use less real leverage and as such would lose much less. On 18th October 2010 the CFTC has issued a new rule which forces forex brokers to provide a maximum leverage of 50:1 for major currency pairs. This rule has been implemented to protect small forex traders.


Learn about forex leverage and other key concepts you need to be aware of when choosing forex brokers.These concepts are explained by forex expert Amit Achameesing.