What Is Leverage in Forex and How Does it Work?

Leverage forms the bedrock of forex trading, empowering traders to control larger market positions while investing only a fraction of the total value. This concept, integral to trading foreign currencies, hinges on utilising borrowed funds from brokers, expressed as a ratio against the trader’s margin. The leverage ratio amplifies buying power, opening avenues for substantial gains, but it equally amplifies the risk of significant losses. As market volatility can swiftly lead to adverse fluctuations, traders must exercise extreme caution and implement robust risk management strategies to navigate the potential downsides of leveraging in forex trading.

Understanding Forex Leverage

Forex leverage allows traders in India to trade large positions than they could with their capital alone. Leverage works by allowing traders to deposit a small amount of capital, known as margin, that is then leveraged by the broker to give the trader access to larger trade sizes. For example, if a trader deposits ₹10,000 and the broker offers 1:100 leverage, the trader can open trades worth ₹10,00,000.

• The maximum leverage allowed is 1:50 for major currency pairs involving the US Dollar, Euro, Japanese Yen, Pound Sterling, and Swiss Franc.
• For other minor currency pairs, the maximum leverage is 1:20.
• This means retail Indian traders can get leverage up to 50 times their margin with major pairs and 20 times their margin with minor pairs.

The leverage limits are aimed at protecting retail traders from taking on excessive risk. Traders in India need to choose forex brokers that offer leverage ratios within the limits set by the Securities and Exchange Board of India (SEBI). You can explore leverage in currency trading, and how it works in the following article.

How Does Leverage Work in Currency Trading?

Leverage allows forex traders to open larger positions than the capital they have deposited. It works by allowing traders to put up only a small portion called the margin, which is then leveraged by the broker.

For example, if a trader has ₹1 lakh in their trading account, and the broker offers 1:100 leverage, the trader can open trades worth ₹1 crore. So with leverage, a relatively small amount of capital can be used to access larger market exposure.

In India, SEBI regulates leverage in forex trading for retail participants. The maximum leverage allowed is:

• 1:50 for major currency pairs like EUR/USD, GBP/USD, USD/JPY etc.
• 1:20 for minor or exotic currency pairs.

This means that with ₹1 lakh margin, a trader can open:

• EUR/USD position worth ₹50,00,000 (1,00,000 x 50)
• USD/SGD position worth ₹20,00,000 (1,00,000 x 20)

Leverage amplifies both profits and losses. A small market movement in the trader’s favour gets multiplied by the leverage, yielding bigger profits. But losses also get amplified if the market moves against the leveraged position.

To manage risk, brokers require traders to maintain a minimum margin level. If the margin drops due to losses, traders will need to deposit additional funds to maintain the position; otherwise, the broker can liquidate the positions.

Relationship Between Forex Margin and Forex Leverage

Forex margin and leverage are closely related concepts in forex trading.

• Forex margin and leverage interconnect significantly within forex trading. Margin represents the necessary funds to initiate a leveraged forex position.
• Leverage facilitates traders to open larger positions than their margin alone permits by borrowing extra funds from the broker.
• The correlation between margin and leverage is evident: higher leverage entails less margin, and vice versa, enabling larger positions with lower initial funds.
• Brokers offer higher leverage with lower margin requirements. Margin requirements are typically a percentage of the full position value.
• The reciprocal of the margin percentage determines the leverage ratio, showcasing the relationship between these two concepts.
• Margin serves as collateral for leveraged positions, while leverage extends a trader’s purchasing power beyond their invested capital in currency trading.
• Together, these concepts empower forex traders to access increased market exposure compared to what their invested capital alone would enable.

Types of Leverage Ratios and Their Meaning

Debt to Equity Ratio

This ratio measures the degree to which a company is financing its operations through debt versus wholly-owned funds. It is calculated by dividing a particular company’s total debt by its total shareholders’ equity. A higher ratio generally means higher risk due to increased debt of the company.

Debt Ratio

The debt ratio measures the percentage of a company’s assets that are being financed with debt rather than equity. You can calculate it by dividing total debt by total assets. A higher ratio indicates greater financial leverage and risk to the company.

Equity Ratio

The equity ratio is a measure of financial leverage calculated by dividing total equity by total assets. It represents the portion of assets financed by equity rather than debt. A higher ratio generally indicates less financial leverage and lower risk for a firm.

Relationship Between Margin and Leverage Ratios in Trading

Margin in trading refers to the amount of money required to open a leveraged position. It acts as collateral for the borrowed funds provided by the broker through leverage. Leverage ratios represent the proportional amount of debt/borrowed funds compared to equity/owned funds in a position. Some common leverage ratios are:

• Debt-to-equity ratio: Measures debt as a proportion of equity.
• The debt ratio: Debt as a percentage of total assets.
• The equity ratio: Equity is referred to as the percentage of total assets.

These leverage ratios have an inverse connection with the margin:

• Higher Leverage Ratios -> Lower Margin Requirements
• Lower Leverage Ratios -> Higher Margin Requirements

For example, a broker offering 1:100 leverage will require a 1%[1]  margin. However, a broker with 1:20 leverage will have a 5% margin requirement.

The higher the leverage ratio, the lower the margin needed to open the same-sized position. This is because more borrowed funds are being used relative to the trader’s equity.

In essence, lower margin requirements allow higher leverage ratios. Margin acts as collateral, while leverage provides borrowed trading funds. An inverse relationship exists between the two in facilitating leveraged trading positions.

State the Risk of Excessive Leverage in Forex Trading

Here are some of the risks traders can face by doing leverage in forex trading. Some of them are as follows:

• Blown Accounts: Excessive leverage can lead to huge losses that completely wipe out the trading capital. This is known as blowing up or busting the trading account. The higher the leverage, the faster losses can accumulate.
• Margin Calls: Leverage requires maintaining a minimum margin level. With high leverage, even small adverse price moves can trigger margin calls from brokers demanding additional funds. Failure to meet margin calls can result in positions being liquidated at a loss.
• Overtrading: Easy availability of leverage can lead to overtrading, where traders open more positions than their accounts can support. This increases the risk of bigger losses.
• Forced Liquidations: As the price moves against highly leveraged positions, forced liquidations become imminent. This can result in accounts being wiped out in a short time.
• Increased Losses: Losses are magnified with excessive leverage, as a small price move results in a much larger loss due to the size of the leveraged position. This can exceed the capital in the account.
• Poor Risk Management: Traders often neglect risk management under the false notion that higher leverage provides security via diversification. This is an important factor to overlook in your currency trade in the forex market.

Risk is the crucial factor you must consider for leverage in currency trading. Depending upon the risk and reward you can take leverage on your currency trade.

How to Manage Leverage Risks?

It’s important to manage your leverage risk in forex, you can go through the following risk and try to avoid this type of risk.

• Use Leverage Judiciously: Leverage is a double-edged sword. Use it wisely per your risk appetite and trading style. Don’t take on excessive leverage just because it is available.
• Follow SEBI Guidelines: In India, retail forex leverage is capped at 1:50 major pairs and 1:20 minor pairs. Stay within the prescribed limits of your leverage.
• Risk Less: Risk not more than 1-2% of your account on a single trade when using leverage. This will protect capital in case of losses.
• Use Stop Losses: Use stop loss orders on all leveraged positions to limit downside risk. Tighter stops may be required with higher leverage.
• Maintain Margin Requirements: Monitor margin levels and ensure there is adequate margin to sustain open leveraged positions.
• Don’t Overtrade: Overtrading and poor risk management are common with easy leverage. Avoid opening multiple marginal positions.

Conclusion

Utilising leverage in forex carries potential benefits or risks contingent upon market conditions and various factors. Diversifying your financial portfolio through investments in multiple assets is feasible. Trading within the currency market presents challenges, yet through learning, application, and refining of trading strategies, improvements are achievable. For a deeper understanding of forex trading, you might want to explore Share India, where you can access insights and collaborate with experts on their trading platform. Remember that leverage within the currency market is a complex concept, demanding caution and diligence in its application during trading endeavours.

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