Leverage in Forex trading
Forex leverage refers to the ability to control larger positions with a relatively smaller amount of capital. Essentially, traders borrow funds from their broker to enter positions that exceed their account balance.
The leverage ratio determines the amount of borrowed funds traders can access. For example, a leverage ratio of 1:100 means that for every dollar of capital, traders can control $100 worth of trading positions.
Traders earn by taking advantage of fluctuations in currency pairs. The profit or loss in Forex is typically measured in pips, which is the smallest unit of price movement in a currency pair. The pip value represents the monetary value of each pip movement. The larger the position size, the greater the pip value, which means that each pip movement will result in a higher profit or loss. Therefore, the larger positions traders open, the higher their potential profits can be. Since utilising leverage allows traders to control larger positions in the market, leveraged trading can potentially amplify their profits.
Leveraged trading provides a lower initial capital requirement, enabling traders to invest in assets with higher nominal values or requiring larger investments. For example, with Octa, you can trade currency pairs with a maximum leverage of 1:1000, commodities with 1:400, indices with 1:400, and stocks with 1:40.
The maximum leverage that Octa offers is 1:1000, meaning that you can hold a position 1000 times larger than your initial investment and potentially earn 1000 times more.
Example of how leverage works in Forex
Suppose you have a trading account with a balance of $1,000, and you decide to utilise leverage with a ratio of 1:100. With this leverage, you can control positions worth $100,000 in the market.
Without leverage, your trading account balance of $1,000 would limit you to trading smaller positions. However, with leverage, you can enter trades with a much larger volume.
Let's say you want to trade the EURUSD currency pair, which is currently priced at 1.2000. Without leverage, with your $1,000 balance, you would only be able to place an order worth 833 EUR (1,000 / 1.2000 = 833.33).
However, with the leverage of 1:100, you can control a position size of $100,000. You can open a trade for 83,333 EUR (100,000 / 1.2000 = 83,333.33).
Now, let's assume the EURUSD price moves in your favour, increasing by 100 pips (0.0100). If you were trading without leverage, your profit would be relatively small: 100 pips * 833 EUR = 8.33 EUR.
With leverage, your profit is calculated based on the total position size, so your profit would be 100 pips * 83,333 EUR = 833.33 EUR.
Margin requirements for leveraged trading
It is impossible to separate the concept of leverage in trading from that of margin. Margin is the minimum amount of money that traders need to deposit with their broker to be allowed to open new positions, including leveraged ones, and keep the initiated orders open. It is a form of security or a ‘good faith’ deposit that ensures traders can cover potential losses from their trades. The margin required by brokers is typically expressed as a percentage of the total trade size.
The margin requirement depends on the currency pair, volume, and account leverage. Use our Octa Trading Calculator to determine the required margin for your orders.
Margin call
Maintaining adequate margin levels is crucial for traders engaged in leveraged trading. Falling below the required margin level leads to a margin call. The event occurs when the account equity (= Account Balance + Unrealised Profits/Losses + Realised Profits/Losses) falls below the required margin level, indicating that the trader does not have sufficient funds to cover potential losses.
When a broker notifies a trader of the margin call, the trader should deposit more money in their trading account to increase their margin or close losing positions and fix the loss in order to free up more margin.
At OctaFX, in the event of a margin call, you’ll receive an email and a notification in the Octa Trading App. A margin call is triggered when your margin level hits 25%.
To avoid margin calls, you should carefully monitor your positions, maintain adequate account equity, and ensure a healthy margin level.
A margin call is a warning for you to take action. If no action is taken, Stop Out occurs next.
Stop Out
A margin call typically occurs before the Stop Out level is reached. Stop Out is a risk control mechanism implemented by brokers to protect traders and maintain market stability. When the account equity reaches a predetermined Stop Out level, the broker automatically closes the trader's positions. This is likely to happen if a trader doesn’t take any action as soon as he receives a margin call.
Stop Out is calculated based on all open positions. The broker will close your positions one by one, starting from the one with the largest loss, until your account equity rises above the Stop Out level. In other words, if you have any losing position, it can lead to the closure of all positions, including profitable ones, until the margin reaches the required level.
Traders must be aware of the Stop Out level set by their broker and take necessary precautions to ensure their account remains above this threshold. At Octa, Stop Out happens at a 15% margin level.
How to choose trading account leverage ratio
Traders can use a trading calculator or a Forex margin calculator to determine the optimal leverage ratio for their trading account. By inputting the desired leverage ratio, traders can calculate the maximum position size they can trade without risking a margin call.
Keep in mind that there is not one best leverage to use in Forex. It is important to consider personal risk tolerance, trading strategy, and market conditions when choosing the leverage ratio.
Short video lesson on leveraged trading
To provide a visual and practical understanding of leverage in Forex and how to avoid Stop Out with margin trading, we have included a short video lesson. In the video, you will be able to review the concepts of leverage, margin, equity, margin level, margin call, and Stop Out on real examples.
This video will further enhance your comprehension of the discussed concepts, offering valuable insights and tips for successful trading.
Risk management in leveraged trading
While Forex leverage allows traders to amplify their potential profits, it also magnifies potential losses. If the market goes against you, you can lose as much as you could have potentially earned. Traders must be aware of the heightened risks associated with leverage.
Let’s return to our earlier example, where you have a trading account with a balance of $1,000, and you decide to utilise leverage with a ratio of 1:100.
You open a trade for the EURUSD currency pair, priced at 1.2000. Without leverage, with your $1,000 balance, you would only be able to open a position worth approximately 833 EUR (1,000 / 1.2000 = 833.33). With the leverage of 1:100, you can control a position size of $100,000. So you open a trade for 83,333 EUR (100,000 / 1.2000 = 83,333.33).
If the market went against you and the EURUSD exchange rate dropped by 100 pips (0.0100), the potential loss would be calculated based on the total position size.
Without leverage, trading 833 EUR, your loss would be 100 pips * 833 EUR = 8.33 EUR.
With leverage, trading 83,333 EUR, your potential loss would be 100 pips * 83,333 EUR = 833.33 EUR.
Beginner traders often overestimate the positive effect of leverage and tend to apply high leverage all the time. This is not always the best practice. Experienced traders, on the other hand, understand the risks of being overleveraged. To reduce these risks, they commonly utilise low leverage and make smaller profits that add up in the long run.
Some good news is that with Octa, you cannot lose more than your initial investment thanks to Negative Balance Protection. Octa guarantees that your risk is limited only to the funds you have deposited into your account. If your balance drops below that amount, we’ll automatically adjust it to zero.
Still, unpredictable market movements and volatility can lead to significant drawdowns and leave you with a negative trading experience. Implementing effective risk management strategies is crucial to mitigate the risks and protect your capital. This includes setting appropriate stop-loss orders, diversifying portfolios, and using position-sizing techniques to limit exposure.
Practise on a demo account
At Octa, we offer free demo accounts with unlimited virtual funds for you to practise leveraged trading. Just like with a real account, you can set your leverage ratio and see how much it affects your potential profit or loss. For beginners, utilising a demo account is highly recommended. A demo account allows you to practise trading strategies, familiarise yourself with the trading platform, and gain hands-on experience without risking real capital. It provides a risk-free environment where you can refine your skills and learn how to manage position sizes.
Final thoughts
Leverage and margin requirements are essential aspects of Forex trading that directly impact profitability and risk exposure. By implementing effective risk management strategies, utilising trading calculators to determine optimal leverage ratios, and staying informed about margin requirements and Stop Out levels, traders can navigate the Forex market with confidence. Remember, leverage amplifies both profits and losses, making risk management a crucial component of successful trading. Always exercise caution, conduct a thorough analysis, and seek professional advice if needed to protect capital and achieve long-term trading success.
