What Is Leverage in Forex Trading?

Leverage is one of the defining features of forex and CFD trading. It allows traders to gain exposure to a larger market position while committing only a fraction of its total value.

That fraction is known as margin, while leverage determines how much larger the position can be relative to the capital required.

Used carefully, leverage can make capital more flexible. Used poorly, it can magnify losses just as quickly as gains. This is why understanding leverage is essential before opening leveraged positions.

Key Takeaways

• Leverage lets traders control a larger position with less capital.
• It is commonly expressed as a ratio such as 1:10, 1:30, or 1:100.
• Higher leverage increases the effect of market movements on both profits and losses.
• The amount set aside to support a leveraged position is called margin.
• Available leverage depends on the broker, instrument, client type, and regulation.
• Leverage should always be considered alongside position size, stop-loss distance, and overall account risk.

Reading Leverage

Leverage is represented as 1:X, where X is the multiplier for your capital. So, for instance, if your leverage was 1:10, you could control a €1000 position by only setting €100 aside.
Naturally, as the position is ten times larger in this example, so are any profits and losses. As such, while leverage can provide traders with more flexibility, it can also make them rack up losses quickly if they aren’t careful.

How Does Leverage Work?

Now that we’ve grasped the basics, let’s look at how leverage works on a specific market example. Let’s say your account leverage is set to 1:10 and you want to open a EUR/USD position sized at 1 micro lot (1,000 units).

You can do so with €100, since your 1:10 leverage lets you amplify your funds tenfold. Now, let’s say the starting position was at 1.2000, and you closed it after it moved 50 pips.

With €100, that would result in a win or loss of around €0.4 if you didn’t use leverage. However, since your profits and losses are calculated from your total position, which has been multiplied by ten and not your initial capital, the win/loss turns into €4.

You can see how even modest leverage levels have a significant impact on profits and losses. In a more extreme example, with 1:100 leverage, the profits or losses of this small move would turn into €40, which is 40% of the capital you initially committed. This is why newer traders should be extremely careful with leverage, as even small moves with high leverage can wipe out accounts in minutes.

Why Do Forex Traders Use Leverage

Price movement in forex is very gradual, often only a few pips, which often don’t even equal a full percentage point on a single position. As such, for most traders, the only way to make meaningful progress is to hold large positions.

Larger positions make even small shifts in percentage meaningful. For instance, a 1% gain on a €100 position is €1, while the same gain on a €10,000 position is €100.

Since most traders can’t afford to commit thousands of dollars to a single position, they instead use leverage to amplify their capital and access these larger positions while committing fewer funds to achieve their desired results.

Of course, these larger positions also increase potential losses, which is why extreme caution is advised with leveraged positions.

How Much Leverage Do Brokers Offer

Leverage levels vary wildly across brokers and regions. One important note is that, for EU clients, ESMA rules cap out leverage at 1:30.

For non-EU clients, brokers often offer leverage into the thousands, but more commonly range in the hundreds.

How Much Leverage Should You Use?

The right leverage for you depends on your strategy, account size, risk tolerance, and numerous other factors. As such, it’s impossible to give a one-size-fits-all suggestion. However, beginner traders are advised to stick to modest leverage levels to avoid excessive losses.

How Is Your Leverage Determined When Trading?

Your leverage depends on your broker. Sometimes you can decide how much to use, and sometimes brokers have default settings.

Here are the most common situations:

• The broker has a default leverage based on client type or account
• The broker decides your account leverage based on your info during the identification process
• The broker lets you choose your account leverage upon registration
• The broker lets you choose your leverage for each trade

While the first few offer limited control, they are actually solid options for newer traders, as they offer appropriate leverage levels for their capital and prevent them from overleveraging. Of course, traders get more comfortable with how leverage works, they will likely want more control with the latter options.

Strategic Uses of Leverage

Leverage is most often used in an attempt to amplify profits, but that’s not its only application.

Traders also commonly use leverage to:

• Diversify: Leverage can allow traders to spread their capital across multiple instruments instead of a single trade. This can help them explore different market ideas and protect their account from sudden shifts in a single instrument.
• Hedge: Traders may use leverage to open positions that offset or reduce risk from another exposure.
• Keep capital available: Leverage leaves more funds available for future opportunities or margin requirements. However, this flexibility should not be confused with safety, as total market exposure can still become too large if risk is not controlled.

These uses still require strict risk management. Diversification and hedging do not remove risk, and leverage can still amplify losses if positions are oversized or poorly planned.

Conclusion

Leverage is a powerful tool if utilized well. However, it can also make positions very dangerous and lead to margin calls, forced position closures, and traders losing their entire accounts.

Forex traders who decide to use leverage to empower their capital need to be extremely careful, have a firm understanding of position sizing and margin requirements, and practice smart risk management to mitigate some of the danger.