Learn / Market Insight / Introduction to Forex Leverage

Introduction to Forex Leverage

November 22, 2021

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There’s a saying that “money never sleeps.” Nowhere is this more true than in the foreign exchange (aka Forex, or FX) market. Each business day, around $5 trillion in currency changes hands across the globe. We’re talking one single day. This massive movement of money presents traders and investors with plenty of market opportunities on a daily basis. But capitalizing on opportunity can also mean engaging risk, especially when leverage is involved. And nearly all FX opportunities are leveraged.

Let’s take a look at this seemingly ongoing flow of international money. What drives the currency market? What is leverage, and how does it work? Most importantly, how can you take advantage of this opportunity without getting burned?

What Makes Money Move?

The foreign exchange market is the conversion of one national currency for another. If you buy Euro with US Dollars, you’ve bought EUR and sold USD. If you’re looking to get back your dollars, then you’re essentially “long” EUR and “short” USD—in other words, long EUR/USD (long euros in exchange for dollars).

When you convert your euro back to dollars, hopefully, your euro has appreciated so that you get a few more dollars back than when you initially made the transaction. As you can see, the value of money is always in motion. But what drives it?

International economic forces, geopolitics, and central bank decisions combine to create the factors that make one currency more attractive and valuable than another. If there is demand for a given currency, then that drives up the currency’s price relative to another currency that has less demand. It’s the simple law of economics: supply and demand drive value.

For example, if five people in a room are in competition to buy €1 (one euro) while there’s only one seller, then the buyers may likely bid higher. One person who’s willing to buy €1 for $1.10, may be outbid by another who might raise it to $1.11. Another jumps in with a bid for $1.12, and another with $1.15.

In the end, the €1 gets sold for, say, $1.15. This means the trade stands at EUR/USD 1.15, or…1 EUR = 1.15 USD.

Of course, in the real world, the units are smaller and slightly more complex.

Understanding Pairs and Pips

Let’s recap the basics, As you can see in our example above, you’re trading two currencies against one another. You’re buying one and selling the other. This makes every currency transaction a “pair.”

If you’re trying to gauge the value of a given currency, like the US dollar, then you have to assess its value in relation to another currency, like the euro (EUR/USD), Japanese yen (USD/JPY), Canadian dollar (USD/CAD), etc. So, you’re always thinking in pairs.

Notice how the USD above is sometimes stated first and sometimes last. The “position” you’re looking at is the Base Currency/Quote Currency.

Think of it in this way: 1 unit of Base Currency = x units of Quote Currency. So, if 1 Euro = 1.15 US dollars, then EUR/USD 1.15. Flip it around and you get USD/EUR 0.87, or 1 US dollar = 0.87 Euro.

FX moves in “pips,” which is short for “percentage of a point.” For most currency pairs (with a few exceptions as with JPY pairs), currencies make a minimum move of 0.0001. That’s 1 pip. In contrast, a move of 0.0010 is ten pips. It may not seem like much but when you’re trading millions in currency as banks do, then 1 pip can be worth a lot of money.

When you trade a currency pair, you trade in “lots.” Different FX brokers offer different lots:

  • Standard lot is 100,000 units (units meaning whatever currency you’re trading)
  • Mini lot is 10,000 units
  • Micro lot is 1,000 units

These are your typical FX lot sizes. But if you’re trading a mini lot of 10,000 units, say in dollars, you don’t need $10k to place the trade. Nearly all FX traders use margin, and this is important to understand, as it can enhance your trading power as well as increase your risk.

What is Margin and How Does It Work?

The words “margin” and “leverage” go hand in hand. That’s because margin, essentially borrowed money, gives you the leverage to control a larger asset value than the good-faith deposit you’re using per trade.

Margin boosts your buying power. If your margin requirement is 2%, for example, then you have 50:1 leverage. This means that for every $1 you use for your trade, you’re controlling $50 worth of a currency.

On a practical note, margin is based on the “base” currency. So, if the EUR/USD were trading at $1.10, then with a 2% margin requirement, you’d need to deposit $2,200 to trade a standard lot of 100,000 units. The math: 0.02 x $110,000 = $2,200.

The benefit is in the buying power, but so are the risks.

The Risks of Margin Trading in Forex

When trading with leverage, your gains and losses will be multiplied relative to the size of your position. Gains can take care of themselves, but losses need to be managed.

For most forex brokers and platforms, falling under the margin requirement may result in immediate auto-liquidation. This means that your platform’s software may reduce or close out your position immediately, depending on which platform you’re using.

When autoliquidation is successful, the good news is that you may not risk losing more than what you have in your account (rarely, market moving events may cause autoliquidation software to fail or flitch). The bad news is that you’re now out of your position and you may not be aware of it.

Ask your broker the percentage at which your positions may be auto-liquidated so that you’re aware of your margin limits.

The Bottom Line

The FX markets can offer potential opportunities for short-term traders and long-term investors. Remember, currencies are in motion 24 hours a day, and nearly 6 days a week. But like any market, you need to understand the forces and mechanics before jumping in. This way you can strategize on exploiting opportunities while reducing market risks.

There is a high level of risk in Margined Transaction products, as Contract for Difference (CFDs) are complex instruments and come with a high risk of losing money rapidly due to the leverage. Trading CFDs may not be suitable for all traders as it could result in the loss of the total deposit or incur a negative balance; only use risk capital.

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