How Leverage Works in the Forex Market

Leverage uses borrowed money (capital) to invest in a currency, stock, or security. The concept of leverage is prevalent in forex trading. By borrowing money from a broker, investors can trade larger positions in a currency. As a result, leverage magnifies the returns from favorable movements in a currency’s exchange rate.

However, leverage is a double-edged sword, meaning it can also magnify losses. Forex traders must learn how to manage leverage and employ risk management strategies to mitigate forex losses.

Key Takeaways

• Leverage, which is the use of borrowed money to invest, is very common in forex trading.
• By borrowing money from a broker, investors can trade larger positions in a currency.
• However, leverage is a double-edged sword, meaning it can also magnify losses.
• Many brokers require a percentage of a trade to be held in cash as collateral, and that requirement can be higher for certain currencies.

Understanding Leverage in the Forex Market

The forex market is the largest in the world with more than $5 trillion worth of currency exchanges occurring daily. Forex trading involves buying and selling the exchange rates of currencies with the goal that the rate will move in the trader’s favor. Forex currency rates are quoted or shown as bid and ask prices with the broker. If an investor wants to go long or buy a currency, they would be quoted the ask price, and when they want to sell the currency, they would be quoted the bid price. 

For example, an investor might buy the euro versus the U.S. dollar (EUR/USD), with the hope that the exchange rate will rise. The trader would buy the EUR/USD at the ask price of $1.10. Assuming the rate moved favorably, the trader would unwind the position a few hours later by selling the same amount of EUR/USD back to the broker using the bid price. The difference between the buy and sell exchange rates would represent the gain (or loss) on the trade.

Investors use leverage to enhance the profit from forex trading. The forex market offers one of the highest amounts of leverage available to investors. Leverage is essentially a loan that is provided to an investor from the broker. The trader’s forex account is established to allow trading on margin or borrowed funds. Some brokers may limit the amount of leverage used initially with new traders. In most cases, traders can tailor the amount or size of the trade based on the leverage that they desire. However, the broker will require a percentage of the trade’s notional amount to be held in the account as cash, which is called the initial margin.

Types of Leverage Ratios

The initial margin required by each broker can vary, depending on the size of the trade. If an investor buys $100,000 worth of EUR/USD, they might be required to hold $1,000 in the account as margin. In other words, the margin requirement would be 1% or ($1,000 / $100,000).

The leverage ratio shows how much the trade size is magnified as a result of the margin held by the broker. Using the initial margin example above, the leverage ratio for the trade would equal 100:1 ($100,000 / $1,000). In other words, for a $1,000 deposit, an investor can trade $100,000 in a particular currency pair.

Below are examples of margin requirements and the corresponding leverage ratios.

As we can see from the table above, the lower the margin requirement, the greater amount of leverage can be used on each trade. However, a broker may require higher margin requirements, depending on the particular currency being traded. For example, the exchange rate for the British pound versus Japanese yen can be quite volatile, meaning it can fluctuate wildly leading to large swings in the rate. A broker may want more money held as collateral (i.e. 5%) for more volatile currencies and during volatile trading periods.

Forex Leverage and Trade Size

A broker can require different margin requirements for larger trades versus smaller trades. As outlined in the table above, a 100:1 ratio means that the trader is required to have at least 1/100 = 1% of the total value of the trade as collateral in the trading account.

Standard trading is done on 100,000 units of currency, so for a trade of this size, the leverage provided might be 50:1 or 100:1. A higher leverage ratio, such as 200:1, is usually used for positions of $50,000 or less. Many brokers allow investors to execute smaller trades, such as $10,000 to $50,000 in which the margin might be lower. However, a new account probably won’t qualify for 200:1 leverage.

It’s fairly common for a broker to allow 50:1 leverage for a $50,000 trade. A 50:1 leverage ratio means that the minimum margin requirement for the trader is 1/50 = 2%. So, a $50,000 trade would require $1,000 as collateral. Please bear in mind that the margin requirement is going to fluctuate, depending on the leverage used for that currency and what the broker requires. Some brokers require a 10-15% margin requirement for emerging market currencies such as the Mexican peso. However, the leverage allowed might only be 20:1, despite the increased amount of collateral.

Note

Forex brokers have to manage their risk and in doing so, may increase a trader’s margin requirement or reduce the leverage ratio and ultimately, the position size.

Leverage in the forex markets tends to be significantly larger than the 2:1 leverage commonly provided on equities and the 15:1 leverage provided in the futures market. Although 100:1 leverage may seem extremely risky, the risk is significantly less when you consider that currency prices usually change by less than 1% during intraday trading (trading within one day). If currencies fluctuated as much as equities, brokers would not be able to provide as much leverage.

Forex Leverage and Margin Calls

A margin call in forex trading occurs when the value of an account falls below the required margin level needed to maintain open positions. In other words, it happens when a trader’s equity is insufficient to cover the margin requirements set by their broker.

Margin is essentially the collateral required by brokers to keep trades open, and when the account balance falls too low, brokers issue a margin call to either deposit more funds or close out positions. The purpose of a margin call is to protect both the trader and the broker from excessive losses.

If the trader fails to meet the margin call, the broker will automatically close out the open positions, which can lead to realized losses. This is known as a forced liquidation. The trader may not have the chance to recover their position if the market moves back in their favor after liquidation because the position would have been closed.

For example, suppose a trader has an account balance of $1,000 and uses a leverage ratio of 50:1, controlling a position worth $50,000. If the market moves against the trader, and their equity drops below the required margin level, say to $200, the broker might issue a margin call. The trader would then need to deposit additional funds to restore the account balance or risk having the broker automatically close the position at a loss.

The Risks of Leverage

Although the ability to earn significant profits by using leverage is substantial, leverage can also work against investors. The primary risk is that even a small adverse movement in currency prices can lead to substantial losses. This magnification of both gains and losses is the core danger of using excessive leverage in the forex market.

As we discussed before, one of the most significant risks of high leverage is the potential for margin calls. If the market moves against their position, the account’s equity can drop below the required margin level. This may require you to deposit more money into your account or have your position be closed.

One understated risk is the psychological impact of trading with high leverage. The large position sizes relative to a trader’s capital can create immense pressure, leading to impulsive decision-making and emotional reactions. Some traders may crave this emotional thrill; for others, the high stakes may negatively impact their well-being, especially if you’ve committed more than you’re able to comfortably lose.

Important

You can lose more money than your original investment when using leverage.

Forex Leverage vs. Equity Leverage

Leverage in forex trading differs from leverage in stock trading due to the nature of the markets and the amount of leverage typically offered by brokers. In forex trading, leverage ratios are generally much higher, and leverage in stock trading is usually far more conservative.

For example, brokers in the stock market often offer leverage ratios around 2:1 or 4:1 for retail investors. The reason stock trading has lower leverage is primarily due to the higher volatility of individual stocks compared to currency pairs. Stock prices can fluctuate significantly in short periods, increasing the risk of large losses when using high leverage. Regulatory bodies like the SEC in the U.S. also impose stricter rules on stock margin accounts to minimize excessive risk.

Another difference lies in the margin requirements. Forex trading typically requires lower margins compared to stock trading, meaning traders need to deposit a smaller percentage of the position’s value to open a trade. For instance, in forex, a trader might only need to deposit 1% of the total trade size to maintain the position. In stock trading, margin requirements are typically higher—possibly around 50% of the position size—especially for day traders.

Strategies to Mitigate Leverage Risk in Forex Trading

There are several things you can do to help manage leverage risks in forex trading. Some of those ideas include:

• Use Lower Leverage Ratios: One of the most effective ways to manage leverage risk is to opt for lower leverage ratios. Instead of using the maximum leverage allowed by the broker (such as 100:1 or 500:1), choose a more conservative level, like 10:1 or 20:1.
• Set Stop-Loss Orders: Stop-loss can be used to manage risk in leveraged forex trades. A stop-loss order automatically closes a position when the market price reaches a predetermined level, limiting the amount of loss that can occur on a trade.
• Limit Position Size: Traders can manage leverage risk by controlling the size of their positions relative to their account balance. Even with high leverage available, you should consider limiting the amount of capital exposed in any single trade. For instance, some traders follow the “1% rule,” where they risk only 1% of their total account balance on a single trade.
• Diversify Trades: Diversification helps mitigate risk by spreading exposure across multiple currency pairs instead of concentrating it in a single position. By holding positions in different markets or currency pairs, traders can reduce the impact of adverse price movements in one market on their overall account.
• Monitor Margin Levels Closely: Keep a close eye on margin levels. Traders should regularly check their account’s margin level to ensure they are not close to a margin call. This proactive approach allows you to manage your leverage risk and avoid sudden forced closures of positions.
• Utilize Risk-Reward Ratios: Traders should adopt a clear risk-reward ratio for each trade to ensure that the potential reward outweighs the risk taken. For example, you could set a rule that is a 2:1 risk-reward ratio, meaning for every $1 of risk, you aim to make at least $2 in profit. Applying this strategy could help you focus in on trades where the leverage makes sense given the expected risk and reward.
• Educate Yourself and Practice with Demo Accounts:
  Before diving into live trading with high leverage, you can practice with a “fake trading account”. Demo accounts allow you to use virtual money to simulate real market conditions without the risk of losing actual funds. This lets you practice setting up leverage trades and gain a better understanding of how forex markets move.

What Is Leverage in Forex Trading?

Leverage in forex trading allows traders to control a larger position in the market with a smaller amount of capital. By borrowing funds from their broker, traders can magnify the size of their trades, potentially increasing both their profits and losses.

How Does Leverage Work in the Forex Market?

Leverage in forex works by allowing traders to borrow money from their broker to increase their position size. For example, with 50:1 leverage, a trader can control $50,000 in currency with just $1,000 of their own capital.

Can I Lose More Money Than I Invest With Leverage?

Yes, it is possible to lose more money than you initially invested when using leverage in forex trading, particularly if the broker does not offer negative balance protection. Without such protection, if the market moves sharply against a trader’s position, the losses may exceed the original investment.

What Is a Margin Call in Forex Trading?

A margin call occurs when a trader’s account balance falls below the required margin level to maintain open positions. When this happens, the broker will request that the trader deposit additional funds to cover the shortfall. If the trader fails to do so, the broker may automatically close the positions to prevent further losses.

The Bottom Line

Leverage in forex trading allows traders to control larger positions with smaller capital, amplifying both potential profits and losses. It works by borrowing funds from a broker, often at high leverage ratios like 50:1 or 100:1, which can significantly increase market exposure. While leverage offers the opportunity for greater returns, it also comes with heightened risk, as even small market fluctuations can lead to substantial losses. Effective risk management strategies, such as using lower leverage and setting stop-loss orders, are really important to manage these risks.