The Forex market(or foreign exchange market) is one of the most lucrative ways to profit in the financial sector. There are trillions of dollars of transactions every single day, and the market is open 24 hours a day, 5 days a week.
The price movements that Forex traders look for are in the hundredths of a cent, so you need to invest a significant amount of money to see any profit.
Brokers offer something called leverage to Forex traders that enables them to take much larger positions than they could normally afford.
What’s the best forex leverage?
Forex brokers offer varying amounts of trading leverage. The maximum leverage depends on the country the broker is based in. For example, current regulations in the United States caps maximum leverage at 1:50.
Other brokers offer varying amounts of leverage from 1:10 to all the way up to 1:500 and even 1:1000!
The ideal forex leverage is 1:50 or 1:100. These amounts of leverage leave you enough room to trade larger positions, but doesn’t let you over-extend yourself.
More experienced traders may wish to use higher leverage of 1:200 or 1:500, too.
What is leverage and how does it work?
Trading forex requires a significant amount of capital which most retail traders don’t have access to. To understand trading with leverage, we need to look at lot sizes.
The smallest lot size in Forex trading is a micro lot, which is still $1,000.
There are three main lot sizes in Forex:
- A micro lot, which is denoted as 0.01 lots, and is $1,000 worth of the currency pair
- A mini lot, which is denoted as 0.1 lots, and is $10,000 worth
- A standard lot, which is denoted as 1 lot, and is $100,000 worth
There’s no limit to how many standard lots you can take. Traders can even place orders of 100 lots or more, provided they have enough capital and leverage to meet the required margin.
So as a retail trader, you need at least $1,000 to take the smallest possible lot size. Even then, you’ll only make $0.10 per pip.
That’s where leverage comes in.
Leverage lets you trade larger positions where your broker will front you the rest of the amount needed for your lot size. This way, you’re only putting up a fraction of the money, and the broker puts up the rest.
You get to keep the full profits, but you also incur the full loss.
Let’s say your account balance is $100 and broker offers you a 1:100 leverage ratio. This means you have an effective buying power of $100 x 100, or $10,000.
Now you want to take a buy position of 0.01 lots on the EUR/USD. You need $1,000 to take this trade, and your broker offers you a 1:100 leverage. That means you only need to put up $10, and your broker will put up the remaining $990.
So now, you’re only using $10 but you’re using borrowed funds to make a lot more money than you could have otherwise.
Leverage is a double-edged sword, though.
You can also lose a lot more money than you could have otherwise.
How leverage can backfire
Since your leveraged account lets you take larger trades, let’s say you got a little aggressive and took a 0.05 lot trade on an account balance of $100.
0.05 lots is $5000, so at 1:100 leverage, you put up $50(only a fraction of the whole lot) and the broker puts up the remaining $4950. Now, you stand to make or lose $0.50 per pip.
Since $50 is tied up in the trade, you can afford to lose a maximum of $50 before your trade is liquidated. That’s because the broker will start to lose money after that point.
If the trade went 100 pips against you, that’s a $50 loss and the broker will issue a margin call and liquidate your trade.
You’ll also lose 50% of your entire trading account!
Does leverage matter if you employ risk management strategies?
In the example above, you saw how high leverage ratios can easily blow a trading account. The solution to this is to use a stop-loss on all of your trades and employ sound risk management to mitigate forex losses.
A good risk management strategy to manage leverage is to only risk a certain percentage of your account per trade. Most traders prefer to risk anywhere between 0.5 to 2% per trade.
This means your stop loss is at a level where you only lose that percentage if it gets triggered.
We can look at another example here:
Let’s say you want to go long on the EUR/USD. Your account balance is $100 and you’re taking a 0.01 lot trade trade($0.10 per pip).
Your trading strategy says that you can only risk 2% per trade, so your maximum loss is $2.
This means your stop loss should be 20 pips away, because 20 x $0.10 = $2.
As long as your stop loss is in place, it doesn’t matter how much leverage you use.
You could use 1:50, 1:100, or even 1:1000. Your maximum loss will always be 2% on your trade.
Note: Depending on the currency pairs you trade, the value of one pip will vary slightly. It will always be the same in major pairs, but cross pairs will have slightly different values.
When do you need high leverage?
Depending on your trading style, you may need to use higher leverage to be able to trade the lot sizes you need.
Some trading strategies employ very tight stop losses and have high risk-reward ratios.
In this case, smaller leverage may not be enough for you and you’ll need different leverage ratios.
For example, let’s say your account balance is $100 and you wish to place a trade on EUR/USD with a 2 pip stop loss and a 10 pip target.
Your risk is 2% per trade, or $2 of your $100 account. Here, you want to trade one mini lot of $10,000, since 1 pip at 0.1 lots is $1.
However, if you have 1:50 leverage, you can only trade a maximum of $5000 or 0.05 lots.
This trade would not be possible to take using smaller leverage.
Related: Can you make a living trading forex?
The Forex markets can offer significant profits if you utilize leverage well, but leverage can also be a recipe for disaster if you’re not careful with your risk.
You’re borrowing money with your own capital to take very large positions. Successful trades will be very profitable, but you also stand to incur significant losses without risk management.
A good ballpark figure to keep in mind when researching a Forex broker is 1:100. This leverage ratio is good enough for most trades, and as long as you set your stop losses and don’t over-extend yourself, you can find yourself on the way to profitability.