Forex Broker Leverage Explained

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Among traders, there is still no unanimous opinion on how much leverage is right for trading. Some people believe that leverage must be low to prevent a trader from opening too many trades, including big-size ones.

Furthermore, a high leverage comes with significant risks for a trader’s account, which is particularly dangerous for novice traders. However, some traders are convinced that a high leverage is a good thing.

From this article, you’ll learn how a trader can benefit from a high leverage and how to choose a reliable broker that is willing to lend you big amounts of money.

Let’s start with defining the word “leverage.” What does this scary term even mean?

In the Forex market, financial leverage refers to a ratio of borrowed capital to a trader’s own investment amount. Leverage gives a trader an opportunity to open positions that exceed their deposit multiple times. By using borrowed capital from a broker, a trader can increase their potential profits.

Let’s take an example for a better understanding.

As you all know, Forex trading is done in lots. 1 lot is equivalent to 100,000 units of a base currency. For example, you’re trading American dollars (USD). Opening a 1-lot position means that you’re willing to buy or sell 100,000 USD units. Logically, 0.1 lot equals to 10,000 units of a base currency (100,000 × 0.1), and 0.01 lot equals to 1,000 units of a base currency (100,000 × 0.01). These are some pretty big numbers! Not every trader has $10,000 in their account, let alone $100,000. This is where leverage comes into spotlight.

Suppose, you have $200 in your account. With 1:200 leverage, you can dispose of the amount that is 200 times bigger than your deposit, i.e. $40,000. This is a huge advantage for a trader, especially since the broker provides leverage absolutely for free.

How does leverage work in trading? Suppose, you open a 0.02-lot position (2,000 units of a base currency) on EUR/USD. In this currency pair, EUR is the base currency. To open the position, the trader will only use 10 EUR (2000 EUR/200) of their own capital. This amount is referred to as “collateral.” Since the trader’s account is in USD, the collateral amount will be converted to USD. Suppose, on the trade opening day, the EUR/USD exchange rate is 1.1205. In this case, the trader’s collateral will equal to: 10 × 1.1205 = 11.21 USD. The broker will provide the remaining 1,990 EUR.

Leverage ratios

Theoretically, leverage can vary from 1:1 to 1:∞. For the most part, the amount of leverage falls into the range between 1:100 and 1:500.

Controlled by the National Futures Association (NFA), American brokers are less generous when it comes to providing loans to traders. The maximum leverage you can count on is 1:50.

Does leverage affect risks?

To answer this question, let’s compare two trading accounts. Account 1 has a 1:50 leverage. Account 2 has 1:500 leverage. In both accounts, a trader opened a 0.1-lot position (10,000 units of a base currency). In both cases, the trader lost 100 pips. Which account will have a bigger loss? The answer is: neither. Losses will be equal in both accounts.

Leverage only affects the size of a collateral. The higher the leverage, the less capital you’ll need to open a position. If leverage is low, prepare to invest more money from your own trading account.

With that said, statements like “high leverage comes with high risks” or “high leverage will deplete your deposit in minutes” have nothing to do with reality. At the same time, you may object by saying that high leverage encourages a trader to open more positions and therefore take more risks, while low leverage keeps your hands tied. While this is a reasonable argument, leverage per se does not force you into opening more positions. It’s the decision made solely by a trader. High leverage allows traders with modest deposits to open big-size positions, that’s all.

ATTENTION! A trader, who is acquainted with money and risk management rules, has nothing to worry about. The size of leverage won’t affect a trader’s risks. If, on the contrary, a trader manages their money irresponsibly, their trading capital will melt fast regardless of the size of leverage, whether it’s 1:10 or 1:1000.

Are brokers with high leverage the best?

High leverages (over 1:500) are mostly provided to the owners of cent accounts or by market makers.

Here are the pitfalls characteristic for all accounts with leverage higher than 1:500 offered by market makers:

  • Conflict of interests. This is a major drawback since your selected market maker will be trading against you. The market maker will be your counteragent, meaning that its positions will be opposite to your positions. For example, if you open a short position, the market maker will open a long position, and vice versa. If you lose, the market maker earns a profit. Therefore, market makers aren’t interested in your success. Partnering with a company that plays against you is hard.
  • Technical issues. Most accounts with high leverages feature instant execution of orders and fixed spreads. In a highly volatile market, instant execution often comes with requotes. Fixed spreads are not the best solutions either, especially when it comes to day trading.
  • Integrity. Unfortunately, the Forex market is no stranger to dishonest brokers. Market makers are often blamed for delayed withdrawals, fake quotations, and other annoying problems.

What is the best leverage to use?

Our tip is to focus on STP, DMA, and ECN brokers with low leverages. Ideally, a broker should operate under the regulation of the FCA UK, Finma or BaFin. CySEC and ASIC are less authoritative but nonetheless reliable regulation agencies.

The highest leverage provided by trusted ECN brokers shouldn’t exceed 1:500. While lower leverages are acceptable, higher numbers increase the risk of coming across a shady broker.

Some brokers offer a so-called “floating leverage.” A floating leverage changes depending on the total volume of your open positions. The larger the volume, the lower the leverage. Why is there an inverse correlation? Because if a trader can afford to increase their trading volume, their trading deposit must have grown, too. The bigger the deposit, the less leverage a trader needs.

Keep in mind that on a Friday night, before the market closes for the weekend or holidays, brokers increase their margin requirements, resulting in a lower leverage. Be careful when opening trades during that time because you’ll need a bigger collateral than usual.

 

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