What is leverage in trading and how to use it properly?

When Forex traders want to increase their position sizes, they can either deposit larger amounts of funds or use a feature called leverage. With leverage, they can increase the overall trading volume, as well as the possible payout amounts. Essentially, leverage is a tool traders can use to borrow funds from their brokers and use them for trading.
 
Various markets use leverage for trading, including Forex, stocks, commodities, etc. However, the Forex trading leverage tends to increase the positions more - usually at 1:200 ratio or so, while on other markets, it usually is lower such as 1:2, 1:5, etc.
 
Leverage is represented by a ratio of two numbers such as this - 1:100, where the first number is the trader's deposit and the second one reflects the multiplication amount. For this example, a deposit of $1,000 will turn into a $100,000 position size and traders will have better chances of receiving higher payouts.
 
When we talk about leverage, it is important to also mention the margin. Whenever a service provider offers leverage, they also demand a certain amount of deposit - a margin - from traders. For example, if the leveraged position size is $50,000, and a margin is 1%, a trader will need to have $500 on their account balance in order to use leverage.
 
But while the leverage has its benefits, there are also risks associated with this feature: it also increases the number of losses received from individual trades, just like it does with the payouts. So, it is important to understand both the benefits and risks of leverage.
 

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Trading requires larger deposits

Forex leverage is one of the most popular features among traders who want to have larger trading positions. And the reason is simple: the larger the position size, the bigger the payouts.
 
In fact, if a trader wants to withdraw, say, $2,000 every month from their account, they probably need to have a position size from $50,000 to $100,000 which will regularly generate payouts. And if a month is not so successful, there will be fewer funds to withdraw.
 
In general, only 1-3% of the returns (payouts) are usually dedicated for withdrawal purposes. That means that just a $100,000 position size isn’t sufficient; a trader needs to actually generate payouts then to withdraw them.

Obviously, $100,000 is a pretty significant sum of money and it is not easy to have a position size that large. But without that, traders are rarely able to get sufficient funds on a monthly basis. However, we are not saying that traders completely stay away from trading or don’t get enough income from Forex, commodities, or other types of trading.
 
Brokers also realize that this is a serious problem and many traders cannot afford larger deposits.
-That is why they offer them loans, so to say. With loans, traders are able to increase their position size and get higher payouts as a result.


What is leverage in trading?

Leverage is often referred to as a loan sometimes. The leverage for Forex tends to go as high as 1:100, 1:200, and more, whereas other markets usually have smaller ones. So, traders can use the leverage to increase their trading position sizes by a significant amount. This, in turn, allows them to get certain benefits:
 
  • Increased payouts
  • Increased capital efficiency
  • Softened effects of low volatility
 
Let’s take a look at each of these advantages.


Increased payouts

The first and probably the most important reason why people use leverage is that it increases the possible payouts. Here is an example of leverage in Forex trading: let’s say you bought EUR/USD currency pair for $1,000 at the price of 1.21 (selling price). This means that you bought around 826 euros with your capital.

However, if you were to use the leverage trade at a rate of 1:200, you would be able to get that same amount of payout in a much shorter time - even one day could be enough for that. This means two things: one, you would have much less work to do.
 
But more importantly, you would be able to return that $200 back into trading much more frequently. This way, your capital could increase at a faster rate, allowing you to trade more intensively and get even higher payouts.


Mitigated impacts of low volatility with leverage in trading

When it comes to trading on a foreign exchange market, there is one thing to keep in mind: the most popular currency pairs like EUR/USD, GBP/USD, and others are more or less stable. This means that the volatility - the speed at which prices are changing - is quite low.
 
As you might already know, one of the main reasons why trading generates payouts is volatility: a quick change in price allows traders to buy an asset when it’s cheap and sell it when it becomes expensive. Since many popular currency pairs can be low on volatility, it is difficult to generate considerable payouts.
 
This is where leverage comes in. Because traders now control much larger position sizes, they purchase even more currency pairs and that minimum difference suddenly becomes significant. The same example of $8 and $1,600 can be used for demonstration purposes.
 

Forex leverage and margin explained

Now, when we talk about leverage and leveraged deposits, we also need to mention what lies behind this tool. When service providers are lending funds to the traders in order to leverage higher position sizes, it might seem to many people that they do so without any insurance; that they entrust their funds with their clients.
 
But that is not what happens in real life. Instead, providers demand their clients to deposit a certain amount of money to their account. This is called a margin and is depicted in percentages.

Here is another example: if a broker provides a leveraged position size of $100,000 and its margin is 2%, it means that a trader must make a deposit of $2,000 with their own money. This way, a broker will lock up those funds in exchange for opening a large position size.


What size of leverage to use in trading?

Up to this point, it may seem to a reader that the leverage is a universal tool that can be applied to any type of trading with high rates and result in even higher payouts. However, different trading strategies tend to require different types of leverage amounts as well.



For example, “scalpers” might use larger leverage rates in general. This is a group of traders who prefer short-term trading operations and usually enter the market several times a day. For them, a higher leverage rate tends to be more beneficial because the smallest change in asset price can be increased by the leveraged position sizes.
 
On the other hand, there are the so-called “position traders” who employ a completely opposite strategy. This is a group of traders who hold their assets; be it currencies, stocks, or anything else, for an extended amount of time. They expect that the longer they wait, the larger the price will get. And for them, lower leverage is usually a more suitable option. That’s because the short-term price changes can go so low that the leveraged losses are larger than the deposited funds, at which points traders are forced out from the operation.
 
In general, if a trader has short-term trading operations and expects to receive payouts in a short time, they usually use higher leverage. When the position times become longer, days, weeks, or even months, traders tend to employ lower leverage.


Watch out for a leverage risk!

As a final point, it is also important to mention some of the disadvantages of leverage because it’s not a totally positive tool. On the one hand, it definitely increases the possible payout sizes and also has other benefits we listed above. On the other hand, however, it also increases the losses that are expected from every trade.
 
Imagine the same example we took a bit earlier, where instead of $8 you earned $1,600 because of leverage. Now imagine that instead of the increase in a EUR/USD price, it actually reduced from 1.20/1.21 to 1.18/1.19. In regular circumstances, you would be able to sell your 826 euros for almost $991, and while you would still lose $9 in total, it wouldn’t be something too damaging.
 
 
However, if you used the same leverage of 1:200, the losses would be even more serious. In fact, the initial $9 multiplied by 200 is $1,800. So, while it’s beneficial to go from $8 to $1,600 in payouts, it’s equally - and often even more - damaging to go from $9 to $1,800 in losses. Therefore, traders need to use this tool very carefully.

 

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Forex Leverage - Beneficial in some cases, damaging in others

So, we’ve taken a look at one of the most popular tools in trading - leverage. Leverage is a way of borrowing funds from a broker in order to increase possible payouts, capital efficiency, as well as mitigate impacts of low volatility.
 
The measurement of leverage is pretty simple: it is represented as a ratio of the initial deposit and the leveraged position size - for example, 1:200. This tool also includes margin - a requirement from the broker that a trader must make a deposit of a certain amount. In the 1:200 leverage, the margin will be 0.5% (1/200x100%=0.5%). This way, service providers can be more certain that a trader will be more responsible with the leveraged funds.
 
But apart from the benefits mentioned above, there are various disadvantages accompanying leverages as well. For example, while it’s easy to increase possible payouts with is, it’s equally simple to make losses more damaging - the same multiplication rate is applied to both payouts and losses. So, the responsible use of leverage is usually the best idea in trading.

Frequently Asked Questions

Do you have to use leverage in Forex?
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Forex is probably the most active market that uses leverage. However, it doesn’t mean that traders always have to use this tool or use it at its maximum ratio.
 
Certain trading strategies require different leverage sizes. For example, those traders who prefer short-term operations usually employ higher leverage because it makes the slightest changes in currency price much more significant.
 
On the other hand, those traders who hold their positions for a longer period of time, would want to use lower leverage rates. These traders expect drastic developments on the market and wait until the price reaches the expected level. But with leverage, they would stand before the risk of losing all their funds because of the short-term price falls.
 
And if someone wants to completely avoid using the leverage, it’s completely possible. Nobody forces them to increase their deposits and make possible gains, as well as losses, larger.
How does margin work when using the leverage in trading?
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A margin is a tool used by brokers on Forex, as well as other markets, for ensuring their financial stability. When they offer leverages, they basically lend their customers their own money. It’s not a surprise that they want to have some guarantees that their funds are safe.
 
To make sure that the funds are actually safe, brokers use margin requirements. A margin is depicted as a percentage and reflects the requirement of the actual deposit. For example, if a leveraged position is $100,000 and the margin requirement is 1%, a trader is required to make a deposit of $1,000 on their own. This makes sure that they are serious about trading.
 
How to use leverage?
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Leverage is a tool used by many traders, as well as offered by many service providers - brokers, for several reasons, among which are increased payouts, access to expensive assets, etc.
 
When entering the market for trade, be it Forex, commodities, or anything else, your broker might usually have a certain leverage amount in their offer package. With just a simple notice, you can incorporate this tool into your trades, making them more effective - but also more dangerous.
 
One thing to keep in mind here is that the brokers usually demand a certain amount of actual deposits from the clients. This means that while you’ll be controlling a large position size in a trade, a certain percentage of that position will be your own money.
 
What are the benefits of leverage?
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There are various benefits of leverage that make this tool so appealing to many traders. The first and most apparent one is that it increases the payout size. If the leverage is 1:200, the payouts will also be increased by x200.
 
Another benefit is that traders will be able to receive their goal payouts much quicker. This way, they will have the ability to return the payouts more frequently to the trading operations, making even more payouts in a shorter period of time.
 
The next benefit is that for certain assets like Forex currency pairs, which usually have lower volatility. Without leverage, a payout would be insignificant. However, leverage makes the slightest change in price much more effective and beneficial.
 
Lastly, the traders who stayed away from expensive assets like gold or Bitcoin will now be able to access them because they control larger position sizes. All that thanks to the leveraged funds.
 

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