It is such a common confusion among FX traders to mix up between the leverage offered to them by their broker with the actual leverage they are using. So, I decided to dedicate a post focusing just on this topic.
Leverage – what is it all about?
As per Wikipedia leverage enables you to buy an expensive product with borrowed funds. A classical use case is the mortgage one pays on his house – assuming a house costs 1,000,000€ and a person has only 200,000€, the rest he will borrow from the bank and use it to buy the house. So actually, using his own funds, he is able to control much more value than he actually has. The risk associated is defaulting on the original mortgage, as a person who can’t pay and sustain these leveraged funds will loss it all and the bank will posses his property.
Leverage works both directions, on one side it enables you to control more value and enhance your profits, on the other hand, it also magnifies your losses. That is the basic, the ground which we will built on the knowledge in this post. So make sure you understand the term clearly.
FX Broker Leverage
In FX, traders must trade high volumes of the product for making a profit. Namely, trading only small amount of funds will create a small value for the trader not worth his time. On the other hand, as most beginner traders don’t have thousands to spend on trading, FX provides an opportunity to start trading with merely 100€ in your account. And how? Using leverage!
The basic unit in FX is called a Lot. Lot is 100,000 units of the product you bought. So, if I bought 1 lot of EURUSD, it means I own 100,000 units of EUR and I expect it to gain value against the USD so I can sell it with profit. Brokers also support mini-lots which are 10,000 units of the underline and micro-lots which are 1,000 units.
The broker states how much margin the trader has to have in his account in order to control a lot. My broker Darwinex, states this value in percentage – https://www.darwinex.com/spreads. For example, EURCAD requires margin of 1%, or 1:100. Meaning that if I open a position of 1 lot, 100,000/100=1,000 USD will be used as margin. If you see EURUSD requires 0.50%, or 1:200, it means that for a lot you only need to have 100,000/200=500 USD.
|Product||Margin||Margin / Lot||Margin / Mini Lot||Margin / Micro Lot|
|EURCAD||1.00% / 1:100||1,000 USD||100 USD||10 USD|
|EURUSD||0.50% / 1:200||500 USD||50 USD||5 USD|
So the more lots you open, the more margin you have to have in your account, otherwise, you will get a margin call and kicked out of the trade, probably with a big loss.
So, the 1.00% or 1:100 is the leverage the BROKER gives you, telling you that with 1 unit you can control 100 units. Thati is the reason you are able to control 100,000 USD with 1,000 USD. But do you want to use it? The leverage offered by the broker is 1:200 for EURUSD, but you really need to keep your effective leverage below of it.
Effective FX Leverage
The effective FX Leverage is one of the most important risk parameters in my eyes. To calculate it, you need to sum net all the open position lots you have, multiply by lot size and divide with your equity. For example, let’s say you have three positions:
- Long EURUSD 0.1 lot
- Short EURUSD 0.2 lot
- Long GBPUSD 0.3 lot
If you sum the lots according to their directions, you will get 0.1+0.3-0.2=0.2, multiply it with 100,000 you’ll get 20,000. Let’s say you have in your account 1,000 USD, it means that your effective leverage is 20,000/1,000 = 1:20. Meaning that for every pip change, you have to multiply it 20 times to see the impact on your account. The more leveraged you are, the more a movement in the wrong direction could wipe out your account. In this example, 100 pips would cause you to loss 100*20=2,000 USD.
I always limit my effective leverage, aiming to have a ratio of up to 1:10 across my portfolio. I also trade the currencies which requires me to have the least margin possible, in my case it is:
Make sure you choose “cheap” products which doesn’t require you large margin to open a position. Keep your effective leverage low so you won’t get wiped out by a volatile movement in the market. Don’t confuse broker leverage with effective leverage, the leverage offered by the broker is massive and you don’t want to use all of it when trading. Don’t be greedy by opening many positions and hope to get wealthy overnight, it doesn’t exist. Open small positions and manage your risk accordingly.