Leverage in forex and other CFDs is a service offered by brokers. It basically allows you to trade more with less money in your account. Leverage is one of the key differences between trading CFDs, which are derivatives, and trading deliverable assets like shares.
This short article introduces the concept of leverage and what it means for traders. Read on to find out how leverage functions and what traders need to know before they trade with high leverage.
How leverage works
Leverage is a service for traders that allows them to open larger orders than would be possible without leverage. Leverage is not a loan. The ratio of leverage is the amount of a trader’s real funds to the amount available for trading with leverage.
For example, if a trader uses 1:100 leverage, it means that for each real dollar they deposit, they can trade as if they had $100 in their account.
Margin requirements are lower when a trader uses leverage. The calculation is as follows:
contract size*lot size/leverage = margin required
Let’s see how the calculation works if a trader wants to buy 0.2 lots of dollar-yen (USD-JPY) with 1:500 leverage:
Margin for 0.2 USD-JPY, leverage 1:500: 100,000*0.2/500 = $40
A trader using 1:500 leverage would need $40 in margin for 0.2 lots of USD-JPY. Without leverage, they’d need a margin of $20,000.
Remember that there’s no need for you to calculate margins yourself regardless which rate of leverage you’re using. You can instead use Exness’ Trader’s Calculator.
Once you understand the basics of how leverage works, you can understand in turn that it can provide both great opportunities and great challenges to traders. Some amount of leverage is in effect necessary to trade: few people can or want to deposit hundreds of thousands of dollars.
Leverage in practice functions to increase both the gains and losses of trading, other things being equal. This is because trading higher volumes effectively amplifies performance, whether good or bad. Inexperienced and reckless traders are more likely to lose than experienced traders.
It’s impossible to state an ideal ratio of leverage for every trader. It depends on each person’s goals, experience, financial circumstances and many other things. That said, you can easily test the effects of using different rates of leverage with different balances by practising with a free demo account.
Does leverage increase risk and cause losses?
The simple answer is ‘no’. Bad trading causes losses and reckless trading increases risk. The reasons for losses are many and varied: they include unrealistic expectations and greed, poor placement of stops and targets, laziness in researching and monitoring trades and a very broad range of other things.
Leverage in itself does not cause losses or increase risk. That said, in practice it does increase the size of any losses (or gains) you would otherwise have made.
Let’s say that a trader using 1:100 leverage sells 0.01 lot of euro-dollar (EUR-USD). Unfortunately, their trade results in a loss of 20 pips, so they lose $2.
If this trader was using 1:2000 leverage instead and exploited this to trade 2 lots instead of 0.01 lot, the result would be much bigger. They would’ve lost $400!
Benefits of using leverage
For good traders, leverage effectively functions to increase profits. As mentioned above, some amount of leverage is basically necessary. For skilled traders, this is both because of margin requirements and making trading a worthwhile use of time.
Imagine a trader makes 100 orders every three months and, without leverage, each one is worth $2. If they profit 60% of the time, gross profit of $120 minus gross loss of $80, this brings their total quarterly profit to… $40. For the average person, this just isn’t worth it.
On the other hand, if this same person used leverage of 1:100, their quarterly profit would be $4,000, other things being equal. Obviously, we need to remember that if the ratio of profits to losses was reversed, 1:100 leverage would mean a quarterly loss of $4,000.
The bottom line is that skilled and successful traders should have no fear of using leverage. Leverage is in fact what makes trading CFDs worthwhile for this type of trader.
Consider your skills
Leverage or no leverage, trading is risky. Financial activities with high potential rewards also come with high risks. If you trade with high leverage and don’t attempt to manage risks, you’ll probably lose a lot of money. However, you’d still lose money without leverage if you didn’t manage risk (you’d just lose less).
Are you a good trader? If you say ‘no’, it’s probably wise to keep your leverage as low as possible if you choose to trade for real. Better yet, practise on a demo account first!
On the other hand, if you generally make consistent profits, you can consider increasing your leverage if you think this is appropriate for you. Exness offers leverage from 1:2 all the way up to 1:Unlimited, the latter once certain volume-based conditions are met.
If you’re completely new to CFDs, it might be a good idea to read our introduction to CFDs before moving on. For more information on the key terms you need to understand to make informed decisions, check out Exness Academy’s practical glossary of trading. You can also read our article on managing risk for the basics of how traders manage risk.