How leverage is used in forex trading

Leverage is widely used throughout the global markets, not just to acquire physical assets like real estate or automobiles, but also to trade financial assets such as equities and foreign exchange or forex.

Forex trading by retail investors has grown significantly in recent years, thanks to the proliferation of online trading platforms and the availability of cheap credit. The use of leverage in trading is often likened to a double-edged sword, since it magnifies both gains and losses. This is particularly relevant in the case of forex trading, where high degrees of leverage are the norm. The examples in the next section illustrate how leverage magnifies returns for both profitable and unprofitable trades.

Let’s assume that you are an investor based in the U.S. and have an account with an online forex broker. Your broker provides the maximum leverage permissible in the U.S. on major currency pairs of 50:1, which means that for every dollar you put up, you can trade $50 of a major currency. You put up $5,000 as margin, which is the collateral or equity in your trading account. This implies that you can initially place a maximum of $250,000 ($5,000 x 50) in currency trading positions. This amount will obviously fluctuate depending on the profits or losses that you generate (note: this and the examples below are gross of commissions, interest and other charges).

Assume you initiated the above trade when the exchange rate was EUR 1 = USD 1.3600 (EUR/USD = 1.36), as you are bearish on the European currency and expect it to decline in the near term.

Leverage: Your leverage in this trade is just over 27:1 (USD 136,000 / USD 5,000 = 27.2).

Pip Value: Since the euro is quoted to four places after the decimal, each “pip” or basis point move in the euro is equal to 1 / 100^th of 1% or 0.01% of the amount traded of the base currency. The value of each pip is expressed in USD, since this is the counter currency or quote currency. In this case, based on the currency amount traded of €100,000, each pip is worth $10. (If the amount traded was €1 million versus the USD, each pip would be worth $100.)

Stop-loss: As you are testing the waters with regard to forex trading, you set a tight stop-loss of 50 pips on your long USD / short EUR position. This means that if the stop-loss is triggered, your maximum loss is $500.

Profit / Loss: Fortunately, you have beginner’s luck and the euro falls to a level of EUR 1 = USD 1.3400 within a couple of days after you initiated the trade. You close out the position for a profit of 200 pips (1.3600 – 1.3400), which translates to USD 2,000 (200 pips x USD 10 per pip).

Forex Math: In conventional terms, you sold short €100,000 and received $136,000 in your opening trade. When you closed the trade, you bought back the euros you had shorted at a cheaper rate of 1.3400, paying $134,000 for €100,000. The difference of $2,000 represents your gross profit.

Effect of Leverage: By using leverage, you were able to generate a 40% return on your initial investment of $5,000. What if you had only traded the $5,000 without using any leverage? In that case, you would only have shorted the euro equivalent of $5,000 or €3,676.47 (USD 5,000 / 1.3600). The significantly smaller amount of this transaction means that each pip is only worth USD 0.36764. Closing the short euro position at 1.3400 would have therefore resulted in a gross profit of USD 73.53 (200 pips x USD 0.36764 per pip). Using leverage thus magnified your returns by exactly 27.2 times (USD 2,000 / USD 73.53), or the amount of leverage used in the trade.

The 40% gain on your first leveraged forex trade has made you eager to do some more trading. You turn your attention to the Japanese yen (JPY), which is trading at 85 to the USD (USD/JPY = 85). You expect the yen to strengthen versus the USD, so you initiate a short USD / long yen position in the amount of USD 200,000. The success of your first trade has made you willing to trade a larger amount, since you now have USD 7,000 as margin in your account. While this is substantially larger than your first trade, you take comfort from the fact that you are still well within the maximum amount you could trade (based on 50:1 leverage) of USD 350,000.
 
Leverage: Your leverage ratio for this trade is 28.57 (USD 200,000 / USD 7,000).

Pip Value: The yen is quoted to two places after the decimal, so each pip in this trade is worth 1% of the base currency amount expressed in the quote currency, or 2,000 yen.

Stop-loss: You set a stop-loss on this trade at a level of JPY 87 to the USD, since the yen is quite volatile and you do not want your position to be stopped out by random noise.

Remember, you are long yen and short USD, so you ideally want the yen to appreciate versus the USD, which means that you could close out your short USD position with fewer yen and pocket the difference. But if your stop-loss is triggered, your loss would be substantial: 200 pips x 2,000 yen per pip = JPY 400,000 / 87 = USD 4,597.70.

Profit / Loss: Unfortunately, reports of a new stimulus package unveiled by the Japanese government leads to a swift weakening of the yen, and your stop-loss is triggered a day after you put on the long JPY trade. Your loss in this case is USD 4,597.70 as explained earlier.

Forex Math: In conventional terms, the math looks like this:

Opening position: Short USD 200,000 @ USD 1 = JPY 85, i.e. + JPY 17 million

Closing position: Triggering of stop-loss results in USD 200,000 short position covered @ USD 1 = JPY 87, i.e. – JPY 17.4 million

The difference of JPY 400,000 is your net loss, which at an exchange rate of 87, works out to USD 4,597.70.

Effect of Leverage: In this instance, using leverage magnified your loss, which amounts to about 65.7% of your total margin of USD 7,000. What if you had only shorted USD 7,000 versus the yen (@ USD1 = JPY 85) without using any leverage? The smaller amount of this transaction means that each pip is only worth JPY 70. The stop-loss triggered at 87 would have resulted in a loss of JPY 14,000 (200 pips x JPY 70 per pip). Using leverage thus magnified your loss by exactly 28.57 times (JPY 400,000 / JPY 14,000), or the amount of leverage used in the trade.

While the prospect of generating big profits without putting down too much of your own money may be a tempting one, always keep in mind that an excessively high degree of leverage could result in you losing your shirt and much more. A few safety precautions used by professional traders may help mitigate the inherent risks of leveraged forex trading:

• Cap Your Losses. If you hope to take big profits someday, you must first learn how to keep your losses small. Cap your losses to within manageable limits before they get out of hand and drastically erode your equity.

• Use Strategic Stops. Strategic stops are of utmost importance in the around-the-clock forex market, where you can go to bed and wake up the next day to discover that your position has been adversely affected by a move of a couple hundred pips. Stops can be used not just to ensure that losses are capped, but also to protect profits.

• Don’t Get In Over Your Head. Do not try to get out from a losing position by doubling down or averaging down on it. The biggest trading losses have occurred because a rogue trader stuck to his guns and kept adding to a losing position until it became so large, it had to be unwound at a catastrophic loss. The trader’s view may eventually have been right, but it was generally too late to redeem the situation. It's far better to cut your losses and keep your account alive to trade another day, than to be left hoping for an unlikely miracle that will reverse a huge loss.

• Use Leverage Appropriate to Your Comfort Level. 50:1 leverage means that a 2% adverse move could wipe out all your equity or margin. If you are a relatively cautious investor or trader, use a lower level of leverage that you are comfortable with, perhaps 5:1 or 10:1.

While the high degree of leverage inherent in forex trading magnifies returns and risks, our examples demonstrate that by using a few precautions used by professional traders, you may help mitigate these risks and improve your chances of increasing returns.

For further reading on forex leverage, see "Forex Leverage: A Double-Edged Sword."