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Forex Education | Experts Love Leverage

Leverage is a word derived from lever. In finance leverage is the use of various financial instruments or borrowed capital to increase the potential return of an investment.

As you can see in Figure 1, using a lever long enough, a 5kg ball could balance a ball 20 times bigger. Archimedes said “Give me a lever long enough and a fulcrum on which to place it, and I shall move the world”. The lever is designed to help one to move heavier objects with less effort.

When it comes to trading, leverage is used to give traders the possibility of increasing their profit by using borrowed capital from the brokerage house. The brokerage house in return asks for a deposit with which traders will guarantee for a possible loss, called margin. The profit or the loss will increase direct proportional with the leverage ratio used.

---------------------------- Example -----------------------------

David and John are two traders. Both know that there is a high probability for the US Dollar to gain against the Euro during the following week because the Federal Reserve is expected to increase the interest rate by 0.25%. David has available 1,000 Euros, while John has 100,000 Euros. In the same time they will go to the same bank to change their Euros to US Dollars. The exchange rate they found is 1.1100. After the exchange David will have 1,110 US Dollars and John will have 111,000 US Dollars.

As expected the Federal Reserve increased the interest rate by 0.25% and the currency rate for EUR/USD has dropped to 1.0900.

David and John go to the same bank in the same time to exchange their US Dollars back to Euros. For the exchange David pays 1,090 USD to get 1,000 Euros and John pays 109,000 USD to get 100,000 Euros. After this exchange David ended up having a profit of 20 USD and John a profit of 2000 USD.

In this example John has 100 times the money that David has to invest, thus the profit John ended up with is 100 times bigger than David’s. For David to have made the same profit as John did, using the same investment, he should have went to a brokerage house which offers a leverage of 1 to 100. This way he would have used his 1,000 Euro as margin and the brokerage house would have given him the possibility to use 100,000 Euro for his trade. The leverage would have helped David to the same profit of 2,000 USD at the end of the two exchanges.

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In the previous example the leverage used was 1 to 100. But there are brokerage houses which give the possibility of using leverages as high as 1 to 500, 1 to 1000 or even 1 to 2000. For experienced traders who do not intend to use high investments to gain from trading, big leverage is a powerful weapon. Experts with high accuracy entries or strong money management systems will use the highest leverage to decrease the margin they need to deposit and benefit from high returns.

On the other hand for amateurs big leverage will only speed up the process of losing their entire deposits. They are the ones who started the idea, the myth, that the bigger the leverage the higher the risk of losing the investment. But the truth is that high leverage presents a risk because it is not used in a correct manner by them.

Higher leverage will give a trader the possibility to use less margin in his trading. This is also called Margin-Based Leverage. Margin Based Leverage = Total Value of Transaction / Margin Required (In our previous example, David had 1,000 Euro, which he could have used as margin in order to have a total value of transaction of 100,000 Euro. In this case the margin based leverage is 100).

In the same time it will give him the possibility to trade bigger volume, or use a higher nominal value. Increasing the volume, a trader will have a higher exposure towards losing more in a shorter period of time. The value of one pip increases direct proportionally with the increase of the traded volume. An increased value of a pip will automatically bring higher profits or higher losses.

Professional traders know this and they adjust their volumes accordingly to their win-loss ratio. Amateur traders will not know to adjust their volume. They will only see the possibility of winning more, and forget about the risk of losing all.

--------------------------------------------- Example ---------------------------------------------------

 

 

Trader A

Trader B

Trader C

Instrument

EURUSD

EURUSD

EURUSD

Balance

€1000

€1000

€1000

Leverage

1:100

1:1000

1:1000

Volume

1 Lot

1 Lot

10 Lot

Margin Required

1000

€100

1000

Pip Value

$10

$10

$100

Pip Exposure

~1%

~1%

~10%

 

Traders A, B and C decided to buy in the same time EURUSD.

Trader A has a leverage of 1:100 and he decides to buy 1 standard lot.  For this volume he will block in margin €1000 and his pip will value $10.

Trader B has a leverage of 1:1000 and he decides to buy 1 standard lot. For this volume, considering the higher leverage, he will block in margin only €100, 10 times lower than Trader A, but their pip value remains the same, $10.

Traders C has a leverage of 1:1000 and he deiced to buy 10 standard lots. He can trade this volume because of the high leverage, and will block in margin €1000. His pip value will be 10 times higher than Traders’ A and B, $100.

As you can observe Trader B, even though he has the possibility of trading with higher volumes, he decided to only use 1 standard lot. Both Traders A and B have a pip exposure of 1%, but different margin requirements. Trader C uses the full potential of his leverage, aiming for higher profits, thus having a pip exposure of 10%.

Let’s consider that the price of EURUSD dropped 10 pips in in the following 10 minutes. After the fall Traders B and A suffered a loss of ~10% ($100), while Trader C suffered a loss of ~100% ($1000). Trade C had a pip exposure too big for his account to handle a small drop of 10 pips.

Try using in the same example leverages of 1:1 and 1:100. The pip exposure will be the one telling you which of the traders will lose more.

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In the previous example I tried to demonstrate that the higher the leverage doesn’t mean the higher the risk. Trader B had a leverage 10 times bigger than Trader A, still both had the same loss. Trader C tried to win big and increased his pip exposure by trading with higher volume just because he could. In this case I would say the bigger the greed and the lack of understanding of risk and exposure caused the loss of the entire investment.

High leverage becomes a weapon in the hands of trading experts. They are using high leverage to make more money in a shorter period of time combined with a high accuracy strategy and well calculated risk to reward ratio. They can use high leverage for low margin requirements in order to apply complex money management systems like scale in and out, or Martingale.Amateurs end up losing their investments and blaming the leverage, the broker and everything or everyone around them.