What is Leverage in Forex Trading? Trading Forex Without Leverage
It's simple, in general terms, leverage means the ability to control a part of something using little to nothing from your resources. In this instance, you get the rest from someone else, subject of course to certain terms and conditions. So how does this apply to forex? What exactly is Leverage trading and what are the risks you need to be aware of if you're going to dip your feet into this pool? In this article, we'll discuss leverage in forex trading and how it feels to trade with or without leverage. Without further ado, let's dive into it.
What Is Leverage In Forex Trading?
We've already explained what leverage means when it comes to day-to-day activities, leverage in forex is pretty much the same. When it comes to forex, leverage involves the borrowing of money from a broker to invest in the market, period. Most of the time, leverages are based on margins and these margins are always calculated based on some factors. However, the general formula for calculating margin-based leverage is to divide the full value of the transaction by the amount of margin that's required of you. To clarify, let's bring up an example
Say, you have to put up at least 1% of your total transaction as margin, you then trade the standard USD/CHF lot ($100,000), this means your margin would be calculated on a 100,000:1 ratio. Hence, your margin would be $1000. This would make your margin-based leverage be 100,000:1000. In a case where the margin required isn't up to that. Let's say the margin required is 0.5% instead, this would make 0.5% of 100,000 200,000 which in turn makes the margin-based leverage 400:1.
Let's say you have $10,000 in your trading account, you then decide to open a standard lot position ($100,000). With the leverage, you would be trading with $100,000 in your account. This is ten times leverage on your trading account. If you have $20,000 in your account, likewise, you would be trading with 200,000, and this is twenty times leverage.
Due to its risks, a trader is advised to only use leverage when they are sure there is an advantage to using it.
Forex Trading With Leverage
By now, you would have seen a bunch of forex sites emphasizing the risks that come with trading with Leverages. Investopedia called it a double-edged sword and you know what? It is.
The most beneficial feature of leverage is that it allows traders to invest with more capital than they have. Most traders consider 1,000 - 1,500 USD to be a good starting point for forex traders. Most of these traders however cannot afford that much capital. This is where leverage comes in. A 1:10 leverage can allow traders to open a lot position of 0.01 with as low as 100 USD. While this might seem like a good opportunity, you must know that it also comes with major risks as well. This would be better explained with an example.
Let's say you purchase 1000 USD for 700 EUR, however, as time goes on, the worth of USD in the forex market reduces by 50%. If you were trading with no leverage, you would only lose half of your funds (in this case, 350 EUR). If you were trading with leverage on the other hand, and you were using a 100:1 ratio, and the worth of USD reduces by as little as 1%, you would lose all your funds. This is why it's important to be cautious and caught up when it comes to risks in which trading with leverage poses.
Try to make sure you're prepared for any loss that can come your way when you're doing leveraged trading. The best way to get yourself familiarized with this is to practice trading with leverage and trading without leverage on a demo account. This way, if you don't see yourself gaining profits with trading that involve low leverage, then you can't possibly expect not to rake in a lot of losses with trading that involve high leverage. This is one of the benefits of a demo account. It allows you to trade risk-free so you don't have to put your capital at risk.
What Is A High Leverage Point?
Have you heard of regulation T? What it does is that it restricts a trader from borrowing more than half of the price of a stock position. When it comes to leveraged trading, there are a lot of requirements put in place to limit risks from anywhere. The stock market for example mandated that there must be a minimum capital available with the trader before leverage can be extended to such trader. This is however not the same with forex trading. Unlike stock trading in which leverage can only go as high as twice the capital, leverage in forex trading can go as high as 10 - 400 times. However, it is not recommended that traders get to the maximum leverage point because a slight negative change in the currency value can make them lose all their funds. The maximum leverage point in this instance is also referred to as the high leverage point. In the futures market, on the other hand, the maximum leverage point is based on the requirements of the margins. Most of the time, this is usually calculated to be 5% or 15% of the whole futures contract.
To give further clarification, let's add some illustrations. So in the stock market, let's say you want to buy $4,000 worth of stocks, the maximum leverage point for you here is $2000. This is because the federal reserve board requires that you deposit at least half of the stock price within your trading account.
In the forex market, the leverage ratio can go higher. Let's say you want to purchase a position of $250,000, you can purchase such a position with a deposit of $5,000. Just know at the back of your mind that the higher your leverage point, the higher your risks.
Lastly, when it comes to trading futures, margin amounts are set by exchanges. These are majorly calculated by the volatility of such contracts. Let's say the price of crude oil per barrel is $60 and you decide to purchase 1000 barrels ($60,000). If the margin is 10% of the contract ($6,000), the amount is the highest leverage point when trading on oil.
Trading Forex Without Leverage
You might be wondering if it's possible at all to trade without leverage. While it is highly unlikely, it is possible in some situations and only when certain conditions have been fulfilled. In this context, you can make a profit off your trading if there's no leverage. However, the absence of leverage can only bring in fruitful profits if you started with a large deposit in the first place. With that being said, there are some situations in which you can trade without leverage
- When you trade in instruments like CFDs on cryptocurrencies, oil, metal, stock indices, and so on. This is because the minimum cost of these instruments is usually lower compared to the forex market. This enables you to earn more profits due to its higher volatility.
- Since it's not possible to open more than 2 trades at the same time, it's reasonable to invest smaller chunks of your capital into these trades without leverage. This would enable you to further diversify your portfolio and average your position.
- Lastly, institutional traders, banks, insurance funds, large companies, and other kinds of investors that deposit billions of dollars into securities so they can rake in more profits at the end of the day. Since these institutions are trading with millions, it's not reasonable that they borrow funds from their brokerage firm. Also, in some cases, the presence of these institutions provides liquidity to security.
Well, there you have it, all you need to know about leveraged trading. We hope you make further research whenever you want to involve yourself in leverage, especially when you want to use the maximum leverage point. Trade safe and have a good day.