Leverage is a facility that enables you to get a much larger exposure to the market you’re trading than the amount you deposited to open the trade. Leveraged products, such as forex trading, magnify your potential profit - but also increase your potential loss.
Forex trading involves risk. Losses can exceed deposits
What is leverage?
Forex trading involves risk. Losses can exceed deposits
Leverage is a key feature of forex trading, and can be a powerful tool for a trader. You can use it to take advantage of comparatively small price movements, ‘gear’ your portfolio for greater exposure, or to make your capital go further. Here’s a guide to making the most of leverage – including how it works, when it’s used, and how to keep your risk in check.
How does leverage work?
Leverage works by using a deposit, known as margin, to provide you with increased exposure to an underlying asset. Essentially, you’re putting down a fraction of the full value of your trade – and your provider is loaning you the rest.
Your total exposure compared to your margin is known as the leverage ratio.
For example, let’s say you want to buy one lot of GBP/USD at 1.2860.
One lot of GBP/USD is equivalent to $100,000 , so buying the underlying currency would require a $128,600 outlay (ignoring any commission or other charges). If GBP/USD goes up by 20 pips to 1.2880, your position is now worth $128,800. If you close your position, then you’d have made a $200 profit.
Unleveraged
If the market had gone the other way and GBP/USD had fallen by 20 pips, you would have lost $200, less than 1% of what you paid for the currency pair.
Or you could have opened your trade with a leveraged provider, who might have a margin requirement of 10% on GBP/USD.
Here, you’d only have to pay 10% of your $128,600 exposure, or $12,860, to open the position.
If GBP/USD rose to 20 pips, you would still make the same profit of $200, but at a considerably reduced cost.
Of course, if GBP/USD fell 20 pips then you would still lose $200, too – a larger loss in comparison to your initial deposit.
Leveraged
Find out more about how leverage affects your trading
Different types of leveraged products
The majority of leveraged trading uses derivative products, meaning you trade an instrument that takes its value from the price of the underlying asset, rather than owning the asset itself. This is the case in forex trading, where you make an agreement with a provider to exchange the difference in price of a currency pair between the time the position is opened and when it is closed.
Find out more about trading forex with IG
There are lots of other leveraged products available, such as options, futures and some exchange-traded funds (ETFs). Though they work in different ways, all have the potential to increase profit as well as loss.
Benefits of using leverage
Provided you understand how leveraged trading works and the way it magnifies risk, it can be an extremely powerful trading tool. Here are just a few of the benefits:
- Magnified profits. You only have to put down a fraction of the value of your trade to receive the same profit as in a conventional trade. As profits are calculated using the full value of your position, margins can multiply your returns on successful trades – but also your losses on unsuccessful ones.
See an example of magnified profit - Gearing opportunities. Using leverage can free up capital that can be committed to other investments. The ability to increase the amount available for investment is known as gearing
- Shorting the market. Using leveraged products to speculate on market movements enables you to benefit from markets that are falling, as well as those that are rising – this is known as going short
- 24-hour trading. Forex markets are available to trade around the clock.
Drawbacks of using leverage
Though forex trading and other leveraged products provide traders with a range of benefits, it is important to consider the potential downside of using such products as well. Here are a few key things to consider:
- Magnified losses. Margins magnify losses as well as profits, and because your initial outlay is comparatively smaller than conventional trades, it is easy to forget the amount of capital you are placing at risk. So you should always consider your trade in terms of its full value and downside potential, and take steps to manage your risk
- Margin calls. If your position moves against you, your provider may ask you to put up additional funds in order to keep your trade open. This is known as margin call, and you’ll either need to add capital or exit positions to reduce your total exposure
- Funding charges. When using leverage you are effectively being lent the money to open the full position at the cost of your deposit. If you want to keep your position open overnight you will be charged a small fee to cover the costs of doing so
Leverage and risk management
Leveraged trading can be risky as losses may exceed your initial outlay, but there are risk-management tools that you can use to reduce your potential loss. Using stop-losses is a popular way to reduce the risk of leverage. Attaching a stop-loss to your position can restrict your losses if a price moves against you. However, markets move quickly and certain conditions may result in your stop not being triggered at the price you’ve set.
There are numerous other tools available to help you manage risk – including price alerts and limit take-profit orders.
What is a leverage ratio?
Leverage ratio is a measurement of your trade’s total exposure compared to its margin requirement. Your leverage ratio will vary, depending on the market you are trading, who you are trading it with, and the size of your position.
For example, a 10% margin would provide the same exposure as a $1000 currency purchase with just $100 margin. This gives a leverage ratio of 10:1.
Often the more volatile or less liquid an underlying market, the lower the leverage on offer in order to protect your position from rapid price movements. On the other hand, extremely liquid markets, such as major forex pairs, can have particularly high leverage ratios.
Here’s how different degrees of leverage affect your exposure (and thus profit potential and maximum loss) for an initial investment of $1000:
|
Unleveraged trading |
Leveraged trading |
|||
|---|---|---|---|---|---|
|
1:1 |
20:1 |
50:1 |
100:1 |
200:1 |
Investment |
$1000 |
$1000 |
$1000 |
$1000 |
$1000 |
Exposure |
$1000 |
$20,000 |
$50,000 |
$100,000 |
$200,000 |
When researching leveraged trading providers, you might come across higher leverage ratios – but using excessive leverage can have a negative impact on your positions.
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Example
Example of magnified profit
Take our example from earlier. With a margin requirement of 10% and a full market exposure of $1000, you’d make a 200% profit on your initial outlay if the market rose by 20 pips – compared to just 20% from the conventional trade. But remember that it if the markets moved against you, your losses would be calculated using the same percentage.
Compare your profit to yout initial outlay if you used conventional trading:
And now with leverage trading:
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