True Leverage

By: DailyForex.com

The related subjects of leverage, margin and position sizing are not only widely misunderstood, they are also usually the key reasons why traders “blow up” their trading accounts. That’s why it is very important to make sure you understand the basics, which can be explained quickly and simply. 

What is Leverage in Forex?

Leverage is your total maximum possible borrowing ratio.

Let’s say that a trader deposits $100 with a Forex broker who allows a maximum leverage of 100 to 1 (this would usually be written as 100:1).

This means that the broker will allow the trader to control maximum funds totaling 100 times his deposit of $100, i.e. $10,000.

Many people trading Forex don’t even understand there is a nominal value to the trades they make. For example, 1 lot of USD/JPY is worth $100,000. Your broker offering maximum leverage of 100 to 1 will not let you buy or sell 1 full lot of USD/JPY unless you have at least 1% of that nominal value deposited in your trading account (1% of $100,000), which is $1,000.

Depending upon market conditions, brokers may require even more than the advertised maximum leverage, which is just the furthest they are ever willing to go under the best circumstances. If conditions are very volatile, brokers typically lower the effective maximum leverage available.

Going back to our example of the trader depositing $100 with a Forex broker giving a maximum leverage of 100:1, that trader could buy or sell at most 0.1 lots of USD/JPY. This is because $100 X 100 = $10,000 and that is worth one tenth of a lot of USD/JPY.

What is Margin in Forex?

Margin is the minimum cash deposit required by the broker to cover any open trades. It is sometimes expressed as a percentage.

Using our previous example, a trader who wishes to buy or sell 0.1 lots of USD/JPY with a Forex broker offering a maximum leverage of 100:1 must deposit at least $100 as “margin” to cover that trade. Margin can be calculated as follows: Trade Value divided by leverage. Here, that is $10,000 divided by 100, equaling $100. Expressed as a percentage, the broker requires a margin deposit of 1%.

What is Position Size in Forex?

“Position size” is the quantity of what is being traded. Every currency pair is quantified by a standardized amount known as a “lot”. The value of a lot fluctuates between currency pairs. For example, as already mentioned, 1 lot of USD/JPY is always worth $100,000 while 1 lot of EUR/USD is always worth €100,000. Note that this means that unless EUR/USD is trading at 1.0000, the real values of 1 lot of USD/JPY and 1 lot of EUR/USD are going to be at least a little different. All lots are not equal!

Most brokers’ platforms express position sizes in terms of lots. Some display other measurements such as nominal value or their own unitary system. It is important to understand how your broker is quantifying position sizes. Traders tend to think in terms of how much cash and how many pips they wish to risk on a trade, making a quick mental calculation of value per pip, and then translating that into lot size. It is a good idea to use a position size calculator, as the cash value per pip fluctuates with market movements. 

What is “True Leverage”?

A trader might open an account with a broker offering maximum leverage of 100:1. If you ask the trader how much leverage he or she has, they may reply, 100 to 1. This is true in a sense, but it is not their “true leverage”, which can fluctuate from moment to moment. True leverage is how leveraged you are from your trades open in the market at any given time.

As an example, let us imagine a trader opening an account and depositing $10,000. His broker offers him maximum leverage of 100 to 1. He opens a position (a trade) in EUR/USD with a nominal value of $10,000. How leveraged is he? Not leveraged at all! He has no true leverage, because his total exposure to the market is not more than his cash deposit. Even if his trade were to fall to a value of zero, he could not possibly lose more than he deposited. 

True leverage is calculated as the total nominal value of all open trades divided by account equity (i.e. how much in cash the account would be worth if all open positions were closed).

Going back to our example, let’s imagine our trader opens another position with a nominal value of $10,000. He is now leveraged at 2 to 1 (we can ignore the small difference that might occur due to the first trade being in floating profit or loss), because he has two open positions, each worth $10,000.

Risk of Margin Call

A “margin call” is when your broker tells you that you do not have sufficient funds in your account to cover all your liabilities. The expression dates from the days before the internet, when trades were made over the telephone. If your margin was not enough to cover your losing trades, your broker would call and require that you either deposited more margin, or gave up on your account and accepted it as empty.

The same thing happens today, instantly and electronically, without the call.

You can use your true leverage to understand your risk of having your account wiped out, or subject to catastrophic losses from which recovery is usually extremely difficult or even impossible.

For example, if your true leverage is 2 to 1, then an adverse total price movement over all your open trades of 50% will wipe out your account.

Here is a table showing maximum adverse movement until wipe out for various amounts of true leverage:

Consider also the following table, showing how much percentage gain is required to recover from various losses to a trading account:

While these numbers might look frightening, you might think that your stop loss orders will protect you from a catastrophic loss.

This is not necessarily correct. Most of the time stop loss orders are triggered with no slippage or with a very small amount of slippage. However, consider that during the Swiss Franc uncoupling of January 2015, most traders who had a true leverage against the Swiss Franc of more than 3 to 1 were completely wiped out, as most Forex brokers ended up quoting enormous price fluctuations without allowing any traders to exit for about an hour or so after the surprise announcement.

The interplay of risk and leverage is a complicated and controversial subject and I will turn to that in the second part of this article, to follow soon.