In this lesson, we will talk about leverage and how it affects your trading.
What is Leverage?
In simple words, leverage is a facility allowing traders to trade with less capital.
As we explained to you previously, 1 standard lot equals 100.000 units. If you buy 1 lot of USDCAD, you are purchasing 100.000 USD and exchanging this for CAD. Another example is that if you buy 1 lot EURUSD, you are buying 100.000 EUR and exchanging this for USD.
However, not everybody has 100.000USD to trade 1 lot. When leverage comes in, a facility from a brokerage provides a “loan” to retail traders so they can join in buying 1 lot with a smaller amount of capital.
Most brokerage firms provide various types of leverage. Some offer leverage of up to 1:500, which is 500 times your money to enter a position in Forex. If you have $1,000 in your account, you can trade up to 500,000 USD or 5 lots, depending on the currency pair.
Here’s an example:
You see a USDCAD pair going higher. You decided to buy 1 lot at the price of 1.2500 (1 USD = 1.2500CAD).
If you do a non-leveraged transaction, you will be buying 100.000 USD, which means now you own 100.000USD in your hand after you exchange from the amount of 125.000CAD.
After some movement from the USDCAD, you decide to close the position (selling back the 100.000USD to CAD), only this time, the USDCAD price has already gone up to 1.2600.
Your 100.000USD has a value of 126.000CAD, meaning you get a 1,000CAD difference.
Now let’s do the Leveraged transaction of 1:100.
You bought 1 lot of USDCAD at the price of 1.2500 and decided to sell at the price of 1.2600.
Because your account is leveraged this time, you get a “loan” from the brokerage to buy a 1 lot equal to 100.000USD. Therefore, you will only need an amount of 100.000USD divided by 100.
This means you’ll only need 1,000USD to buy 1 lot.
So you own 1 LOT USDCAD, which equals 100.000USD in your account. Instead of using 100.000USD or 125.000CAD, you only need 1,000USD or 1,250CAD. When you decide to close the position, you will get the 1,000CAD as profits.
In comparison:
In a non-leveraged transaction, you get a profit of 1,000CAD using a 100,000USD or 125,000CAD, which is equal to 0.8% profits.
In a leveraged transaction, you get a profit of 1,000CAD using a 1,000USD or 1,250CAD, which equals 80% profits!
Now, let’s look at another example:
You want to buy 2 lots of EURUSD at the price of 1.1500 and close the position at the price of 1.1550, which is equal to 50 pips (explained in our previous lesson).
So, you buy 2 lots of EURUSD to “own” 200,000EUR at 1.1500 or equals 230,000USD.
How much will you need when using the leveraged account of 1:100?
You will need 200,000EUR divided by 100. That is a minimum of 2,000EUR at 1.1500 or 2,300USD.
Now, you are closing the position from 1.1500 to 1.1550 (a profit of 50 pips). You now “own” 200,000EUR at the price of 1.1550 or equals 231,000USD. Your profit is 1,000USD.
So, you only need 2,300USD to buy 2 lots of EURUSD at 1.1500 to get a profit of 1,000USD when you close the position at 1.1550, which equals 43,47%!
There is a huge potential to profit in the Forex market using less capital.
Nice, right? But you must remember this…
Based on the examples above, leverage amplifies the amount in your account when you are doing a transaction.
Leverage amplifies your profit potential. However, it also works the other way, increasing your risk potential!
Using the same EURUSD example above:
You want to buy 2 lots of EURUSD at the price of 1.1500 with the hope that the price will increase and profit from it. However, EURUSD falls to 1.1450.
How much are you losing?
So, you buy 2 lots of EURUSD to “own” 200,000EUR at 1.1500 or equals 230,000USD.
How much do you need when using the leveraged account of 1:100?
You will need 200,000EUR divided by 100, which means you are using 2,000EUR at the price of 1.1500 or equals to 2,300USD.
Now, the price is moving below your buying price to 1.1450, which means you are in a losing position of 50 pips. This means you “own” 200.000EUR at the price of 1.1450 or equals 229,000USD. Your loss is 1,000USD.
Since the price is moving against your position, you are experiencing a loss of 1,000USD or 43.47%.
Let’s see what happens if we only have a 10,000USD account in our leveraged trading account and experience a bigger loss. What will happen with the “loan” amount and the account?
Your starting balance is 10,000USD with leverage of 1:100.
You bought 2 lots of EURUSD at the price of 1,1500, which means you need 2,300USD from your balance to make the trade. Your balance is 7,700USD.
The price is going lower, which means you are experiencing a loss.
If the price goes down to 1.1450, you will lose a 1,000USD,
If the price goes down to 1.1400, you will lose a 2,000USD,
If the price goes down to 1.1350, you will lose a 3,000USD. The loss exceeded your capital for buying 2lots EURUSD in the first place.
This is also eating your remaining balance. Now you have only 7,000USD left in your account.
If the price goes down to 1.1300, you will lose 4,000USD and be left with a 6,000USD account balance.
If the price goes down to 1.1250, you will lose 5,000USD and be left with a 5,000USD account balance.
What happens if the price reaches 1.1000 and you still haven’t closed the position?
You will lose 10,000USD.
Maybe you are thinking, “but I own a 200.000USD for 2 lots!”.
Remember that it was a “loan” from the brokerage, and your real initial balance is 10,000USD. Therefore, if you lose 10,000USD, the market will eat all your initial balance. Based on the broker’s account rules, the brokerage has the right to close your position before it exceeds your balance.
Takeaway
Based on the above examples, it is a must to understand that leverage is a double-edged sword; on one side, you can get a high-profit potential transaction. On the other, your risk potential can get high.
