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June 3, 2022

LiteFinance, Everything you need to know about "Leveraged Forex Trading" (Part 1)

Here is the part 1 of Leveraged Forex Trading educational series. Learn how Leverage works in Forex.

Everything-you-need-to-know-about-Leveraged-Forex-Trading Everything-you-need-to-know-about-Leveraged-Forex-Trading

Leverage is an interest-free loan offered by a broker. You can use leverage to increase your open interest, thereby increasing your profits. Alternatively, you can use leverage to reduce margin (collateral that brokers require traders to provide when opening a position).

Read on and you’ll learn what leverage is and what it does. You will also learn how to calculate and find the best leverage. I will explain all the pros and cons of leverage in forex trading and provide real-world examples of using leverage in forex trading.

Also, you will learn useful and interesting information about Forex leverage.

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What is leverage? Leverage Definition and Meaning

Imagine you buy apples in a wholesale market in a big city and sell them in a local market in a small town. Obviously, there is a certain extra cost involved in shipping the apples from the wholesale market to the small town.

The more apples you buy at the wholesale market, the more money you make on markups (provided you sell all the apples). Your cash is limited. You know you can sell 5 times more apples in your local market, so go to the bank for a loan.

Forex leverage is simply a type of bank loan offered by brokers to forex traders. If your deposit is relatively small, by using leverage, you can buy several times more currencies or stocks, thereby earning several times more profits.

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What is Forex Leverage?

But there are significant differences between bank loans and foreign exchange leverage. Forex traders can use leverage for free at any time, and brokers offer loans but do not charge interest on that loan.

Financial leverage in forex trading is:

  • A tool that enables traders to trade with positions that are several times higher than the actual amount deposited.
  • A margin trading tool whereby if you run out of assets, you can borrow funds to increase your position and thus increase your profits.
  • The ratio between your deposit and your open interest.

The trading conditions of each trading account specify the maximum leverage for foreign exchange trading. For example, one account will have a maximum leverage of 1:200; another account will have 1:1000.

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Forex leverage example:

1:1 leverage means that traders can only trade with their own funds. The ratio between the trader’s deposit and the amount he/she trades. That is, if a trader has $100, he/she cannot open a position with a total open interest of more than $100.

Leverage of 1:1000 means that a trader can hold 1000 times the capital he or she has. This means that if you have $100, your open interest can be $100*1000 = $100,000.

Which leverage is the safest? The minimum leverage allowed is 1:1.

There is theoretically no upper limit on leverage, so you may encounter forex leverage of 1:3000. However, the financial regulator strongly recommends that brokers lower the maximum leverage limit to reduce the risk of traders losing their deposits. ”

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Leverage vs Margin – Differences and Relationships

Another effect of leverage is to increase the amount of money traders can use as collateral to open and hold positions.

For example, for a leverage of 1:100, in this case, to open a position with 1000 units of the base currency, the trader would need 100 times less capital, which is 10 units of the base currency.

This money, called margin, is the amount that the broker freezes until the position is closed.

Margin is the money on your account that should be used as collateral in order to be able to trade foreign exchange using leverage.

A common formula for calculating margin is as follows:

Margin (collateral) = open interest (contract size, lot) / leverage

For example, if you traded $100 with 1:2 leverage, the margin requirement would be 100/2 = $50

Let’s study an example EURUSD (EUR/USD) position with 1:1 leverage:

Let's study an example EURUSD (EUR USD) position with 1 1 leverage

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Total assets

This is the amount deposited by the trader, and its value is equal to the balance (deposit amount at the time of opening the position + profit/loss from opening the position). If the position is closed immediately, it will be the amount on the account. During the opening of a position, the amount is floating.

Assets used (margin, collateral)

These are the funds that the broker freezes while you trade. This is the deposit amount directly related to leverage.

Available working capital is the amount of free capital available to traders. It is the difference between total assets and margin. This amount is floating because it takes into account the current profit/loss of the opened position.

In this example, I made a trade with a minimum lot size of 0.01 (the trading conditions did not provide for a smaller volume), which required $1,127.21. This amount is shown in the “Assets Used” line and I have a little over $872 in free funds. This means I can’t make another trade because I don’t have enough funds.

I opened the same demo account, but with 1:10 leverage, and made three trades with a volume of 0.01 lots. By using 1:10 leverage, I need 10 times less capital to make a similar trade with the same effect. In this way, I can make 10 trades with a volume of 0.01 lots at the same time (for example, using several instruments). Or I can make a trade but with a volume of 0.1 lots.

Leverage-2-en

The minimum deposit should be slightly above $1127.21 to trade with a minimum volume of 0.01 lots with 1:1 leverage. With leverage of 1:1000, the margin would be $1,1272. That is, you have $1.13 of your own funds enough to make such a trade.

Another conclusion from this example. The higher the leverage, the lower the margin, which means that traders have more of their remaining funds to trade.

Margin is the amount that the broker reserves when a trader makes a trade. As shown in the following table:

Leverage Margin requirements (collateral held by the broker, expressed as a percentage of open interest)
1:1 100%
1:2 50%
1:5 20%
1:10 10%
1:100 1%
1:1000 0.1%

If you trade with 1:1 leverage, the margin requirement is equal to the open interest (the broker keeps 100% of the open interest as collateral).

When using 1:100 leverage, if you trade with the same volume, the broker only keeps 1% of the open interest.

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Why trade with leverage in the Forex market?

You can trade without any leverage. However, in some cases leverage can make it easier for you to achieve your financial goals or/and increase your profits. E.g:

Even if you have a small deposit, you can open a position with the minimum allowed volume (usually 0.01 lots). When you have $10 (or even $100) deposited, you cannot trade certain assets without leverage. Therefore, financial leverage may be the only opportunity for a novice trader to start trading. You will learn more in the next section.

You can increase your position. Imagine your deposit allows you to trade EUR/USD with a volume of 0.01 lots, where 1 pip is 10 cents (for a four-digit quote).

Example: You are 100% sure that the price will rise 10 pips in the predicted direction. Without leverage, you would get 10*10 = 100 cents ($1). When using 1:100 foreign exchange leverage, you can trade 100 times more with a trading volume of 1 lot. The profit of 10 up points will also increase 100 times – $100. However, the risk management rules state that you should not trade with your full deposit, but this is just an example to show how leverage works in Forex trading.

You can make more trades and thus increase your deposit. Example: You have $100. When you open a position with a volume of $100 (no leverage), the broker immediately reserves that capital to open the position for you. All deposits are frozen and you cannot make further transactions.

If you use 1:10 leverage, the broker will only reserve $10 for a $100 trade. You can then use the remaining $90 to make new trades. For example, you can trade other assets to spread your risk.

If you open several demo accounts with different deposits, different leverages and do some different trades, you can better understand what Forex leverage is.

You can do this in a few simple steps:

  1. Register a profile on LiteFinance. This will only take a few minutes of your time.
  2. Click the METATRADER tab to the right of the transaction chart in the client profile.

Click the METATRADER tab to the right of the transaction chart in the client profile.

Click the OPEN ACCOUNT button, select the leverage, and after creating the account, set it as the master account. In this way, you will open a live account and a demo account at the same time. To switch from one account to another, go to the Metatrader tab again and convert the desired account to the main account.

go to the Metatrader tab again and convert the desired account to the main account.

Demo accounts offer leverage ranging from 1:1 to 1:1000. On live trading accounts ( Classic and ECN ), the leverage range is also from 1:1 to 1:1000.

How to check your account leverage on the MT4 platform? There is no such direct option in MT4 (calculation based on margin ratio does not make sense).

Such an option is available in the trader profile, where you can also open an MT4 account and attach it to the terminal with a login and password. You can view the leverage for each account in your profile. You can also change the leverage by going to the Metatrader menu on the right.

change the leverage by going to the Metatrader menu on the right.

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How does leverage work in forex trading?

Let’s take a look at how Forex leverage works in real trading on the LiteFinance trading platform.

Suppose you have deposited $100 in your investor account and want to trade the EURUSD pair at the current exchange rate of 1.13. According to the trading conditions, the minimum trading volume is 0.01 lots.

According to the trading conditions, the minimum trading volume is 0.01 lots. Since 1 lot is 100,000 units of base currency, a trade volume of 0.01 lot will be 1000 units of base currency. That is, a trading volume of 0.01 lots means that you are buying at least EUR 1000, for which you need to have funds above $1130. But with only $100 in your account, the platform won’t let you bill at all.

Suppose you have deposited $100 in your investor account and want to trade

If you use 1:10 leverage, you can manage $1000. But that’s not enough. It is clear from the image that you have a deposit of $1000, but you receive a message that your account is insufficiently funded and you cannot open a position.

When you use a leverage of 1:20 (a fairly safe leverage for novice traders from a risk management point of view), you will be able to trade with a volume of 0.02 lots.

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