How to Use Margin and Leverage in Forex Trading
If you’re getting into forex trading, two words you are going to hear a lot are margin and leverage. When you trade on margin, or trade using leverage, you are able to control more money than you possess, giving you the potential to make very large profits even with a small bankroll. Of course, the reverse is possible as well; you can also lose a great deal of money very quickly.
Leverage is not a strategy in and of itself for planning trades or exiting them profitably; it is a method for managing your money. In this article, I will help you understand how leverage works, and introduce you to its benefits as well as its drawbacks so that you can make an educated decision whether you want to trade on margin or not.
What is Leverage Forex Trading?
When you trade using leverage in forex, you are borrowing money from your broker to place larger trades.
This is a major attraction to forex trading for a lot of retail investors because most retail traders have relatively small bankrolls. There is a good chance you are starting out with just a few hundred or thousand dollars in your account. If you trade without leverage, it will take you a long time to build that account.
If you trade on leverage however, it is as if you possess far more money than you actually do. You can enjoy the same kinds of returns that you would be able to if your thousand-dollar account was a $10,000 or $100,000 account.
How to Trade with Leverage
How to make use of leverage is best understood through the following forex trading leverage example.
Margin Forex Trading: A Practical Example
Leverage is expressed using a ratio. The higher the ratio, the more money you are borrowing from your broker. Imagine you have $100 in your forex account. If you do not borrow any money for trading, and you control no more than that $100, that is referred to as 1:1 leverage. Technically, you are not using leverage at all.
Now picture that you still have $100 in your account, but you are trading using 100:1 leverage. That means you are controlling 100 times the amount of money in your account, which equates to $10,000.
Let’s say that the value of the asset you are trading increases by $100. Imagine two scenarios:
- In the first, you are trading with 1:1 leverage, and you have $100. You invest 1% of your account going long. Your total return is $1.
- In the second, you are trading with 100:1 leverage, and you have $100. You invest 1% of the leveraged amount ($10,000) going long. Your total return is $100.
Obviously, there is a massive difference between the measly 1% you made in the first scenario and the whopping 100% you made in the second scenario. Who wouldn’t want to double their account size in a single trade?
In this example, the $100 you are using to control $10,000 with 100:1 leverage is referred to as your margin. This can be expressed as a percentage. Since $100 is 1% of $10,000, it is 1% margin.
So, saying that you are trading with 100:1 leverage is the same thing as saying you are trading on 1% margin, and vice versa. You can choose other degrees of leverage as well: 20:1 (5% margin), 50:1 (2% margin), 200:1 (.50% margin), and so on.
Here Is What Can Go Wrong with Leverage Trading
Let’s return to the scenarios discussed previously where you were going long with 100:1 leverage. Now imagine that the asset loses $100 in value instead of gains it.
If you were trading 1% with 1:1 leverage, you would only lose $1 (1% of your $100 bankroll). But if you were trading 1% of the leveraged sum with 100:1 leverage, you would lose $100 (your entire bankroll).
Ouch—one mistake and you have just blown away your entire account! Now that is a bad day.
When something like this happens, and your margin is no longer sufficient to sustain your position, you receive what is known as a margin call.
1% ($100) was the required margin for the position. You lost $100, so you no longer can meet the margin requirement. That 1% is gone. This is where the margin call comes in. It is quite literally a demand from the broker that you deposit the required margin to continue holding your position. That would mean you need to deposit another $100.
What if you fail to do this? At this point the broker can close as many of your open positions as need be to restore the margin requirement. In some cases, brokers will even liquidate past this point, which will result in further losses. On top of that, you may be charged fees.
So not only will you lose your initial investment—there is a chance that you could end up in the red.
This does not mean you should never trade on margin. What it does mean is that you should be very, very careful with it.
Pros of High Leverage Forex Trading
- Control more money than you have in your account.
- Grow your account quickly if you win your trades.
- Trading on margin is a fairly simple concept once you get the hang of it.
- Trade with brokers that require specific lot sizes (see the next section).
Cons of High Leverage Forex Trading
- Trading on margin introduces more math into your money management calculations. This added complexity can easily throw off your perception. You may invest more than you intend to.
- While you can gain money quickly, you can also lose it just as fast.
- If you get a margin call, you might end up owing the broker commissions even after losing everything.
Which Brokers Are Offering Leverage Forex Trading?
Trading with leverage in forex is really common. In fact, most major forex brokers offer it. Indeed, quite a few essentially demand it.
How so? Well, many brokers force you to trade specific pre-determined ‘lot’ sizes. For example:
Standard: 100,000 units
Mini: 10,000 units
Micro: 1,000 units
Nano: 100 units
For traders with small bankrolls, it is impossible to trade these lot sizes without the use of leverage. So if you trade on sites without custom lot sizes and you have a small account, you will be using margin to do so.
Trusted Brokers That Offer Margin & Leverage Forex Trading in 2018
Can You Trade Forex Without Using Leverage?
Trading with a small bankroll and plan on using a conservative money management strategy? When you first find out that most brokers require a specific lot size, you may feel discouraged, as you would be forced to use leverage.
Thankfully, even in the past when large lot sizes were more ubiquitous, there were a few brokers which allowed forex trading without margin. These days, there are even more that allow trading without leverage.
The broker most highly recommend for non-margin forex trading is Oanda. On Oanda, you can set custom lot sizes, trading as little as one unit. This means trading forex with low leverage, or even no leverage is entirely possible, even if you have a small bankroll.
So for example, if you open an account with $100, and you want to invest 2% of that, you can literally stake $2 on your trades. Yes, it is very slow going, but it is also responsible, and a lot less likely to blow your account than margin forex trading.
You now know all about leverage forex trading and you have a thorough understanding of the upsides and downsides. When you trade using margin, you can grow your account overnight, or destroy it just as quickly. If you choose to trade with leverage, take great care that you know what you’re doing and that you understand the consequences if you lose a trade. Most traders should steer clear of margin trading altogether. Lasting success is built on slow, regular, consistent gains.
Q: Should I trade with leverage?
A: Probably not. If you talk to successful traders, you will find out that most of them stake surprisingly little money on their trades as a percentage of their accounts. Most professional forex traders are only risking around 1% to 3% of their accounts on any particular trade. Rather than trying to trade more money than they control, they are trying to limit the risk to only a small portion of their bankrolls.
Q: What is an appropriate, conservative percentage of my account to be trading?
A: As stated above, around 1% to 3% is appropriate. It is best from a conservative standpoint to go no higher than 5%, and even that is pushing past what many skilled traders would consider responsible. Even if you have a really good trade setup, you might think that surely, a higher percentage is called for. Actually, you should only ever be taking really good trade setups. So this is still not a justification for wagering more, or for trading with leverage. It’s recommended that you take the best setups, and you should only risk around 1% to 3%.
Q: How can I find the patience to trade without leverage on a small account?
A: If you feel overwhelmed by the thought of making only a few dollars per position with your non-leverage to forex trading, that is understandable. After all, you were probably hoping when you got started that you would be making 100% returns right off the top, and thousands of dollars would be pouring into your account overnight.
Indeed, a lot of retail traders with small accounts do not find the patience they need, which leads to overtrading or irresponsible use of leverage. More often than not, this leads to a single result, which is failure.
This is why trader psychology is such a big deal. If you want to be successful, you need to accept that in the beginning, you will probably be making very small profits. You may need to get rid of the timeline in your head and learn to focus on trading well, not on getting rich overnight. If you can do this, you can grow your account gradually but exponentially. Eventually, this should lead you to the incredible profits that you are dreaming about now.