Lesson 9: How to Understand & Calculate Forex Leverage

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The use of leverage is one of the key features that distinguishes online trading and traditional investing. In the mind of the average trader, there are certain prejudices about leverage which are perceived as a disadvantage of the forex market.
For this lesson, I do not want to write a long post so I will immediately focus on the essence of what leverage really is, how to calculate it, and how to use it correctly. I will try to explain it as simply as possible.
Leverageis the ratio of the value of the lots you want to trade to the value of your deposit. In other words, it is the ratio of your own funds to funds you borrow from your broker to open a position.

LET’S CONSIDER AN EXAMPLE

Let’s say that in your trading account you have $1000 and you are going to buy 1 lot of EURUSD, which is priced at $100,000. To enable you to open that position, the broker must turn your $1000 into $100,000 by temporarily loaning you the missing funds. The result is 1:100 leverage.

Similarly, if you have $1000 in your account and you are going to buy 1 lot of an asset, whose value is $50,000, you only need leverage of 1:50.Here is a final example: You have $100,000 in your account and you want to buy 1 lot of EURUSD. Thus, you use yourentire deposit in the transaction and you do not need borrowed funds. In this instance, you are trading without leverage or at a ratio of 1:1.
If you are wondering what kind of deposit is necessary for trading with a particular amount of leverage, use the calculator below. In practice, your broker’s trading platform will calculate the margin on its own and you only need to determine thesize of the trading position that reflects your strategy. We will cover this in more detail in the next lesson

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IS THERE ANY POINT IN SEARCHING FOR A BROKER WITH LOW OR HIGH LEVERAGE?

It depends on your goals. When we look at the listing of all of the different instruments that the broker provides for trading, we see that each one is assigned a maximum leverage. Thus, for any given instrument, your broker should be clearly stating to you the maximum leverage that it is willing to provide. When opening a position, you have the ability to determine the amount of your own deposit and of the borrowed funds that are involved in the transaction.
Leverage conditions vary greatly between brokers. The ratios can range from 1:50 (the maximum allowed for brokers doing business in the United States) all the way to 1:1000.
Importantly, even if the broker’s website has indicates that it can provide a maximum leverage of 1:1000, this does not necessarily mean that you will be able to get it. Today, almost all of the brokers are regulated by the same organizations. My broker is regulated in Europe and, due to the rules, they are obligated to ask clients to fill out a questionnaire. They use this to calculate the maximum amount of leverage that they will offer you.
It is my general opinion that the amount of leverage should not be the determining factor when choosing a broker. However, if I had to choose between a broker with low leverage and another with a high ratio, I would choose the one with the maximum. As a reminder, no one is obliged to apply maximum leverage in every transaction.

Is the high leverage harmful or useful?

On the market there is a strong opinion regarding the use of the high leverage. It is based on the fact that a margin trade comes with high risks.


Let’s see what risk a trader assumes when using a large amount of pledged capital.

WHEN A BROKER GIVES YOU A LOAN, IT CANNOT LOSE THAT MONEY. THIS MEANS THAT YOU CANNOT LOSE MORE THAN WHAT YOU HAVE IN YOUR ACCOUNT.

Let’s suppose you have $1000 in your account and you want to buy 1 lot of EURUSD, which is priced at $100,000. It is easy to calculate that buying that 1 lot uses $1000 of your own trading funds and $99,000 are the broker’s funds (borrowed funds—or a credit, in other words). This means that the amount of your own funds is one hundredth of the total amount, so at that point in time, you are using a leverage of 1:100.
In this example, you opened a buy position, which means that you expect the price to increase. But what happens if the price goes against you by going down?
It’s time to talk about a situation called a margin call.

WHAT IS MARGIN CALL?

If you were trading with a real broker, your phone would be ringing. Let’s return to our example: You still have $1000 in your account, but the price goes against your position. Floating (not fixed) loss on the transaction is approaching $900. This means that if the price unfolds right now, all your money will remain in the account, but if the price goes a little further down, your deposited funds in the account will run out.
In this situation, the person who opened a trading position for you will call you and tell you about the need to add the additional funds to the account to secure the transaction. Here the word “margin call” literally means a phone call.

Now, in the age of the Internet trading, brokers do not call the customers and the definition of the term has changed.

Margin Call is the automatic closing of your trading position when the minimum security deposit level of the transaction is reached.
Our example of $1000 is rather abstract since, in reality, the size of the minimum security deposit for any transaction depends on:

  • The broker;
  • The type of trading account of the broker;
  • Trading instrument.

There are three major conclusions that you should draw from this lesson:

  1. Under no circumstances should you deposit more funds in the account if you see that the position is likely to be closed by a margin call. In 99% of cases, if the price is already approaching the margin call, your transaction is doomed to fail and replenishing the account to extend your position will only increase your losses. Let the transaction close, take a breath, analyze the strategy in a calm manner, and open a new trading account or replenish the current one.
  2. Trust me, every trader has been margin called and it should just be taken as a part of the learning process. The most appropriate thing to do in this situation is to calm down and start with a blank sheet.

  3. Pay attention to the size of the security deposit (margin level) at your broker, especially if you are going to «overclock your account». The next point of our lesson will tell you what it is all about.

MARGIN CALL AND STOP OUT

Another technical point of this topic is the difference between the concepts of margin call and stop out. Theoretically, the margin call is a call (a broker´s warning) which, in reality, means a notification about the low amount of available funds in your account. Stop out is the immediate, forced closing of the trading position by a broker. Today, there exist 2 types of situations:

  1. Where margin call and stop out are one and the same.
  2. Where margin call and stop out are at the different levels.

For example, at a margin level of 25%, the margin call might occur (usually the entire line in the Trade tab in the trading terminal starts to turn red), and the stop out (forced closing) occurs at the level of 10%.
As a rule, if in the trading terms of the broker only specify the margin call level, then we are dealing with the first case. If the level of of both margin calls and stop outs are specified, then we are dealing with the second case. Be aware that the percentage levels at which your broker takes these actions can vary.

HOW TO OVERCLOCK THE DEPOSIT?

Let’s consider the pros and cons of overclocking a trading account..
Why did you start trading in the first place?What goals do have you set for yourself for the time horizons of a month, six months, a year, or five years? What do you need to do to achieve these goals?
Perhaps you understand that, in any business—and trading can be perceived as a business—startup capital is required.

Like in business, in trading, a large amount of startup capital is more likely to interfere at the very beginning of your path. Most impatient traders just siphon off all the available funds, no matter the amount. The causes of this phenomenon are purely psychological: greedand euphoria.
If the goals in trading are approached globally, though, most people in this industry agree on the following:

  • Raise good trading capital. For example, something like $300-500,000 USD;
  • Earn 5-15% per month, take out certain amount for your needs, and reinvest or put the rest aside

If you try to calculate how many years it will take to grow your account from $100 to half a million, even earning 15-20% per month, it will result in a rather large number. That is why many traders who start with a small amount first tend to overclock. That is, to multiply the deposit in a short span of time in order to move to a more rational strategy in terms of risks.

WHY DO YOU NEED ALL THIS?


I am aware that it is difficult to have $100 in your account and maintain a reasonable approach to the risks of each trade. It can be very difficult to achieve great results. Most often, traders who do not overclock their accounts tend to show good dynamics (a flat curve of account equity growth growth without large collapses) in order to demonstrate the effectiveness of their trading strategy, and then take the investments, or open a PAMM account for attracting funds from outside investors.
In general, this is a good alternative to overclocking the deposit. We’ll talk about PAMM accounts and about managing someone else’s funds at the end of my course.

It may seem that overclocking of the deposit implies unconstrained risk management; but if you think about it, you will understand that isn’t necessarily the case.
If you ask me what I mean by overclocking, I will answer the following:

  1. trading without stop loss (the first failed transaction will mean a siphoned off deposit);
  2. starting with small capital; and
  3. high yield (hundreds of percent per month).

In this case, the most important point is the first one.

This strategy means that the first failed tradewill kill your deposit. Most likely, even if you have made 5 profitable transactions in a row, and the sixth one is unsuccessful, you will have to start everything from the beginning.
Strangely enough, I find many more plusses than minuses in this approach.
But I would not want to record just this idea out of the whole course in the minds of my readers. Everyone has to decide on their own to what extent such a trading strategy is acceptable. Below, I present some arguments for and against overclocking your deposit.

THE DISADVANTAGES OF DEPOSIT OVERCLOCKING

The tactics that lead to the first failed trade killing your deposit contradicts all the risk and money management rules that we will discuss in the next lesson. Such a strategy, in the short term, can greatly affect your psyche. If the loss of a deposit is not the part of the strategy, it’s pretty hard for every trader to accept such a turn of events.
At a certain level of overclocking, it is quite difficult for a trader to stop and switch over to more conservative trading.
It is the final one out of these points that I consider to be the main argument against overclocking of a trade deposit. When a trader manages to make $10000 from $100, there are no thoughts in his mind about why it is worth changing his strategy. There is a big choice here: either take a step back and start again from $100 or to try using $10,000 to make a million. Again, according to my experience, the majority of traders choose the second variant. And they make a fatal mistake.

The primary goal of overclocking the deposit is to do so much that it will be possible to move on to a more reliable approach which will surely be able to generate income over a long period of time.

It is surprising, but as a rule, it is enough just to change the risk management for a transaction (we will talk about all the indicators in the next lesson). This means that instead of 100% of the deposit, it is enough to risk, for example, 5%. All the other trading rules, such as the entry point and exit point, can be left unchanged. This is not a very difficult transition to make.
Nevertheless, it is rather difficult to come to this point without making mistakes. However, maybe that’s the way it should be.
Now I will tell you about the advantages of overclocking the deposit.

ARGUMENTS FOR

  • It’s much more interesting
  • For many traders, over time, their trading becomes routine and they begin to see their work as follows:

    A situation where the risks are maximal but you can quickly scoop a large profit suits many people in terms of their temperament and maintains high adrenaline level.

  • The ability to “grow” quickly.
  • As mentioned earlier, he question is what to do with this money. Do you switch over to a more rational approach or do you risk it all again?

  • There is the possibility of developing a good strategy.
  • Strangely enough, such unconstrained trade can have a positive effect on the learning process and on the development of a trading strategy, especially for the beginners. First of all—maybe not at once— you will learn to wait for a good setup, to stay focused, and evaluate the chances. You can learn how to be patient owing to a few siphoned off deposits.

  • Forex is not as volatile as it may seem.

Virtually all of the financial markets have come to the point that most of the small intraday movements are caught and executed by trading robots (high-frequency traders or HFTs). This is why scalping has practically died (we will cover this in more detail in another lesson). Many traders have switched to swing trading on the daily timeframe and open positions with long time horizons that can last for several days, a week, or even longer. From the perspective of risk management, they look much more interesting than the intraday ones. We will cover this in another lesson.
To come back to overclocking the deposit, such a strategy may mean that in any given day, you may not have very many good opportunities to open a position. Therefore, it is better to make one good trade than 10 average ones. If you make 1 good trade a day, you can take great risks.

HOW DO I OVERCLOCK THE DEPOSIT?

This lesson would be incomplete if I did not share my tactics of overclocking the deposit. In fact, I fit the description of the trader who did not change his strategy or risk management much after growing the account equity through overclocking.
I try to make a few good trades each day that the market is open, with one condition:. Immediately after a good deal, I withdraw money from my account and leave the previous capital.
For example, I have $100 in my account. I make 2 consecutive risky but profitable earn a total amount of $250. As a reminder, if one of them turned out to be unprofitable, I would lose my entire deposit. After these two trades, I withdraw a profit of $250, leaving my account equity at the original $100. This may not seem like a profitable business, but if you calculate the final profit at the end of the month, you can achieve a good yield.
Of course, from time to time you have to recharge your account with an additional $100. Technically, this issue is solved by the existence of two trading accounts. You just periodically transfer funds from one account to another one via your profile. This happens instantly, or within 1 business day, depending on the broker.
We will end the lesson on this note. You probably have a lot of thoughts and ideas right now and you should work through them carefully. I would like you to debate with me in the comments about concerning which strategy is the best for the beginner to start from, with what amount of leverage to trade, and what results to strive for. In the next lesson, we will focus on risk management and I’ll tell you why my approaches are different from the common ones. It will be interesting!
Yours sincerely, Pipbear

KEY TERMS OF THE LESSON

Leverage | Margin Call | Overclocking the deposit

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