Leverage is a system that plays an active role in the investor’s involvement in the financial markets and enables larger volume transactions with less capital. In this post, we will take a look at what leverage trading is. Let’s get started.
Forex Trading: Leverage Trading 101
The leverage ratio, which plays an important role in making the market more popular than other financial markets, differs from country to country. The leverage ratio in Forex transactions made is determined as 1:10 in most countries.
How should the leverage ratio used in the Forex market be interpreted?
If the maximum leverage ratio used in the Forex market is 1:10, it means: 1000 dollars can be traded with 10 thousand dollars. If the investor wishes, he can make an investment ten times the amount of his capital (collateral) or collateral, in other words, he can open a position. Profit and loss calculation is calculated over this transaction volume.
What should be the basic rule of the trader when using leverage?
Benefiting from the leverage effect of the investor with the right strategies creates high profit opportunities. On the other hand, high risk appetite, wrong strategies and trading with market reverse positions create the same risk; this is a discipline that should not be ignored in all transactions. Because when the investor opens a position with a higher lot than his collateral, he may face the risk of losing all or a large part of his capital. To put it more clearly, generally, in case the investor’s losses expand, the deposited collateral melts and the position is closed by the intermediary institution (stop out) or by the investor. Therefore, it is very important for the investor to make effective collateral management while using leverage.
How is leverage calculated?
In Forex transactions, the profit/loss ratio is calculated entirely according to the change in the unit price of the instrument, and the profit/loss amount is calculated according to the size of the transaction volume.
We use the following formula when calculating the leverage ratio;
Leverage = Position size (Unit Price x Quantity) / Position Margin (Margin)
For investors who want to find the leverage ratio, you can find out how much trading volume you can create with your collateral by using 1:10 leverage for gold and Euro/USD parities by putting the data in the table below into the formula. From another point of view, we can use the same formula to calculate how much collateral we need by using 1:10 leverage for the trading volume you will make.
Example of Leveraged Gold transaction
1 ounce Price $1,200
Position Size $12,000
Leverage= 12,000/1,200= 10
“How much collateral do you need for a 1 lot gold investment?” or “How much can you invest at 1:10 leverage with $1,200 collateral?” You can easily answer these and similar questions through the following example.
First, let’s calculate the value of the position;
Lot sizes in the Forex market differ in instruments. Since we gave an example on the gold transaction, 1 Lot = 100 ounces in gold. Let’s say 1 ounce is worth $1,200. In this case, the value of 1 Lot gold transaction = 10*1200$ is equal to 12 thousand dollars. In other words, 1 Lot gold transaction; The ounce price is from $1,200 to $12,000. In other words, the size of the opened position is 12 thousand dollars.
So how much collateral do you need for this position? How much collateral do you need for a $12,000 volume? Or you have $1,200 in collateral or you want to use $1,200 of your collateral and how much can you trade using 1:10 leverage? We can calculate the answers to these questions using the same formula.
Volume = Collateral * Leverage
$12,000 = $1,200*10
When we calculate it by substituting it in the leverage formula; With a leverage of 1:10, we make a trading volume of 12 thousand dollars using a collateral of 1,200 dollars.
So how much would you invest if you did not use leverage, what is the advantage of leverage?
Let us illustrate the answer through two scenarios. Let’s give an example of an unlevered transaction in the first scenario, and an example of a leveraged transaction in the second scenario.
Scenario one: You can only invest $1,200 with $1,200 collateral without leverage. Your gain or loss is calculated on this rate. For example; At a 1% increase, your earnings will be $12.
Earnings = $12
Second scenario: Using 1:10 leverage, you make an investment of 12 thousand dollars by trading 1 lot of gold with a collateral of 1,200 dollars and your earnings will be 120 dollars at a one percent increase.
Can You Reduce Leverage With Collateral Management?
The correct use of leverage is especially important for investors who are new to the financial markets. In Forex, which is a leveraged market, both profit and loss occur in a short time as a result of the leverage effect. So, does lowering leverage ensure successful risk management?
If you want to both take advantage of the high leverage ratio and reduce its disadvantages when investing. It can relatively change the reflection of leverage effect with money management strategy. If we explain through this example, the investor can reduce the effect of leverage by keeping the initial margin ratio high.
We recommend the following golden rule to investors in this regard: The margin used for all positions open at any time should be between 2 percent and 5 percent of the initial margin. If you are very confident in your strategy, this rate can be increased to 10-15 percent of the initial margin.