Leverage Meaning – FX Guide
A trader uses leverage to invest a currency, stock, or security with borrowed capital (called equity). In Kenya, leverage dominates the currency market. Investment brokers provide investors with the ability to grow their currency holdings by lending them money.
As a result, leverage magnifies the impact of favourable changes in exchange rates. However, as well as boosting profits, leverage can also magnify losses. By managing leverage and utilising risk management strategies, forex traders in Kenya will have a greater chance of reducing losses.
If you are finding out the leverage meaning and its use, this article is for you.
What does leverage mean in the Forex market?
With daily trades worth over $5 trillion, the foreign exchange market is the largest globally. In forex trading, traders attempt to influence the exchange rate of currencies by buying and selling currencies.
Brokers display forex rate quotations and quotes. Currency investors interested in purchasing a currency are quoted the asking price, and those interested in selling the currency are quoted the bid price.
The euro could be brought against the dollar (EUR/USD), hoping to increase its value. For example, an investor who bids $1.10 would purchase EUR/USD. After a few hours, if the rate moves in the trader’s favour, the position will be unwinded by selling back to the broker the same amount of EUR/USD they purchased.
An exchange rate difference between the buy and sell rates determines the profit (or loss) on a trade.
Forex traders in Kenya can increase their profits by utilising leverage. Investing in the foreign exchange market offers investors the opportunity to leverage their investments extremely high. The broker provides the investor with a loan, which is called leverage.
Having a forex account allows a trader to borrow funds or trade on margin. The amount of leverage that a new trader can use is limited at first by some brokers. As a general rule, traders can adjust the amount and size of their trades according to the leverage they prefer.
For each trade, the broker will need some cash on margin, called initial margin, which is a percentage of the notional amount of the trade.
How can you calculate leverage?
Calculating leverage requires consideration of the following factors:
- Amount of trade (its notional value)
- Margin percentage
Brokers assign traders margin percentages which serve as a basis for calculating the minimum equity that must be posted to start a trade. A margin is the equivalent of a deposit. Calculate the equity required to execute a trade by multiplying the margin percentage by the trade size.
Investing equity = margin percentage x size of trade
To calculate leverage, divide the size of the trade by the amount of equity.
Trade size/equity = leverage
The following example illustrates how leverage can be calculated using those formulas:
- Size of trade: A mini contract costs $10,000 when traded on USD/JPY.
- Margin percentage = 10%
Equity = margin percentage x trade size
0.1 x $10000
Leverage = trade size/equity
$10000 / $1000
= 10x or 10:1
In the example, forex leverage is used as a fundamental component of trade entry. However, traders should not simply calculate how much money they need to enter a trade and deposit that amount directly into their account. Positions moving in the opposite direction can result in margin calls if the account equity falls below a level deemed acceptable by the broker.
The risk of large losses is present when trading forex with leverage. Therefore, we have calculated a typical scenario to determine the impact of using excessive leverage on a trading account.
Traders can experience both positive and negative outcomes when using leverage. Therefore, it is vital to figure out the appropriate leverage and adopt a risk management strategy.
Kenyan Forex traders who use stop losses minimise their downside risk. Ideally, you should risk no more than 1% of the account equity on every single trade and no more than 5% of the account equity on all open trades at any given point in time.
Kenyan traders also pursue higher probability trades over time by using a positive risk-to-reward ratio.
Tips to learn leverage
- You should familiarise yourself with the basics of forex trading if you are new to it
- Trading with leverage requires the use of stops. The use of guaranteed stops eliminates the risk of negative slippage during extremely volatile markets.
- Don’t use too much leverage. A good rule of thumb is not to use more than 10% leverage.
- Avoid margin calls by understanding the forex broker’s margin policy.
Types of the leverage ratio
Every broker has a different initial margin requirement based on the size of the trade. For example, investors buying EUR/USD for $100,000 may be required to hold $1,000 in their account as margin. Thus, the margin requirement would be $1000 / $100,000, i.e., almost 1%.
By using leverage, a broker can increase the size of a trade by multiplying it by the margin it holds. Using the initial margin example above, the leverage ratio for the trade would be 100:1 ($100,000 / $1,000). Essentially, if an investor deposits $1,000, he can trade $100,000 in a specific currency pair.
The following examples illustrate margin requirements and leverage ratios.
|Margin requirement||Leverage ratio|
From the table above, we can see that leverage is increased with a lower margin requirement. Depending on the particular currency being traded, however, a broker may require higher margins.
For instance, the exchange rate between the GBP and the EUR can fluctuate dramatically, causing large swings in the rate. Therefore, for more volatile currencies and volatile trading periods, a broker may ask for more collateral (i.e., 5%).
Other leverage ratios
Financial leverage can also be measured by other ratios such as:
- Debt to EBITDA Ratio
- Debt to Capital ratio
- Interest Coverage ratio
While the Debt to Equity Ratio is the most commonly used ratio to measure a company’s leverage, the three ratios listed above are also commonly used.
Forex leverage and trade size
Different brokers in Kenya may have different margin requirements for larger and smaller trades. The 100:1 ratio means that the trading account must be collateralised with at least 1/100 = 1% of the total value of the transaction.
For an investment of 100,000 units, the leverage provided might be 50:1 or 100:1, depending on the size of the trade. With positions of $50,000 or less, a higher leverage ratio, such as 200:1, is usually used.
Investors can often execute smaller trades, such as $10,000 to $50,000, with lower margins at some brokers. However, new accounts may not qualify for 200:1 leverage.
An average Kenyan broker allows 50:1 leverage for a $50,000 trade. The minimum margin for a trader with a leverage ratio of 50:1 is 1/50 = 2%. This means that for a $50,000 trade, $1000 in collateral would be needed.
You should be aware that the margin requirement will change based on the leverage for that currency and what the broker requires. For example, some brokers require a 10-15% margin requirement for emerging market currencies like the Kenyan Shilling. Despite the additional collateral, the maximum leverage may only be 20:1.
To manage risk, forex brokers may increase margin requirements, decrease leverage ratios, and ultimately reduce the size of positions held by traders.
Forex markets are generally characterised by greater leverage than equities markets, which offer a 2:1 leverage, and futures markets, which offer a 15:1 leverage. It may appear extremely risky to trade with 100:1, but the risk is considerably less when you consider that currency prices change by less than 1% when trading intraday (on the same day). Brokers would be prevented from offering as much leverage if currencies fluctuated as much as equities.
Trading forex with excessive leverage
Real leverage is a double-edged sword since it has the same potential to enlarge your losses as well as your profits. You assume more risk if you apply more leverage on your capital. The risk of margin-based leverage is not necessarily the same, although it can influence if one is not cautious.
This point can be illustrated with an example. Both Trader X and Trader Y have a trading capital of $10,000 and trade with a broker that requires a 1% margin deposit. After analysis, both agree that EUR/USD is on the top and should go down. Therefore, both EUR/USD broke to 120.
Trader X decides to apply 50x real leverage to this transaction, reducing EUR/USD to $500,000 ($50 x $10,000) based on his trading capital of $10,000. Since USD/JPY is 120, one pip per EUR/USD for one standard lot costs around 8.30 USD, so one pip per USD/JPY for five standard lots costs around 41.50 USD.
If EUR/USD rose to 121, Trader X would have lost 100 pips on that trade, equating to $4,150. That single loss accounted for 41.5% of his total trading capital.
Trader Y is a more cautious trader and chooses to apply five times real leverage on this transaction, which reduces USD 50,000 worth of EUR/USD (USD 5 x USD 10,000) based on his trading capital of USD 10,000.
This USD/JPY is worth $50,000, only half of the standard lot. If EUR/USD goes up to 121, Trader Y will lose 100 pips on this trade, which equates to a loss of 415 USD. This single loss is equivalent to 4.15% of his total trading capital.
Leverage – a double-edged sword?
While foreign currency leverage makes the tedious forex market interesting and a sweet deal, keep in mind that too much sugar can lead to diabetes!
In the example above, if USD/INR depreciated from 73.3834 to 72.3834, Sam would have lost his entire capital of Rs 10,000 in one day!
If you handle leverage up to 120 times, even a 50 step drop can damage the invested capital. In Mr. Sam’s case, his losses increased every 50 times he fell on the field.
Therefore, you should be very careful when choosing a foreign currency leverage ratio. You also need good risk management to counter the double-edged nature of leverage in forex trading.
What is the best leverage ratio for beginners in the forex market?
Without a doubt, leverage is the main attraction of the forex market. Without currency leverage, traders may have to wait months to see their positions change by 10%.
But as attractive as it may seem, leverage in forex trading is a risky undertaking. There are three rules to keep in mind when choosing the best leverage ratio:
- Always start with low leverage when trading forex.
- Always use stop loss to protect your capital and minimise your losses
- Release only 1% – 2% of your capital with every transaction.
There is no definite formula for choosing the best leverage ratio. Your risk profile depends on how much capital you want to risk and how much volatility you can handle.
Leverage, or borrowing money to invest, is a very common feature of forex trading. By lending investors money, brokers can help them acquire larger positions in a currency.
Although leverage magnifies gains, it can also magnify losses, which can be considered a two-edged sword. For example, in trade, a percentage is often kept in cash as collateral, and for certain currencies, a higher percentage may be required.
The upside of leverage is obvious, but if you cannot keep up with interest payments, it can end up costing you much more than you borrowed.
Investing funds that are not your own is particularly risky. So at least when it comes to investing, leverage should be reserved for seasoned professionals, at least until you have experience and can afford to lose money.
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Heinrich is a forex and CFD enthusiast with a passion for writing good informative quality content. He strives to showcase the best forex brokers in Africa. Join him on his Journey!
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