Every trader eventually encounters the concepts of leverage, margin, and collateral. Once they understand the underlying principles, traders often split into two groups:
- Some believe high leverage inevitably leads to deposit loss.
- Others see it as a useful tool, especially for diversification through small collateral amounts and sufficient free funds.
There are also other advantages and disadvantages. Let’s explore what leverage really is.
What Is Leverage?
The role of the broker is to provide the trader with the necessary amount of funds under margin trading conditions. Thus, the main principle of margin trading is providing leverage.
For example, a leverage of 1:100 means that to buy or sell 10,000 units of the base currency, you need 100 times less—just 100 units of the base currency. This amount is called margin (from the English word ‘margin’ meaning collateral) and is calculated in the base currency using the formula:
Margin (Collateral) = Contract Size (Lot) / Leverage
How Does Leverage Work?
Leverage can range from 1:1 to 1:500 (and even higher). Let’s calculate. Compare two types of leverage: 1:500 and 1:100—and find out how much you would lose using them when trading an EUR/USD lot of 1 on a $10,000 account, assuming a stop-out at a 10% margin level.
For example, with a leverage of 1:500, a position of 10,000 units of the base currency requires a margin of 20 units of the base currency (10,000 / 500).
With a leverage of 1:500, $266.42 is used as collateral. $10,000 – $266.42 = $9,733.58 remains for trading. You would lose $9,733.58 if there is a drawdown of 973 points (four-digit quotation) at a point value of $10. At this point, the margin level will be 100%, meaning only your collateral of $266.42 remains. A stop-out occurs when 10% of the collateral is left ($26.6). So, you are left with $266 – $26 = $240, which means only 24 points remain before a stop-out. In reality, the stop-out would occur at a drawdown of 973 + 24 = 997 points, leaving $26 on the trading account after the stop-out.
With a leverage of 1:100, $1,332.10 is used as collateral. $10,000 – $1,332.10 = $8,667.90 remains for trading. You would lose $8,667.90 if there is a drawdown of 866 points (four-digit quotation) at a point value of $10. At this point, the margin level will be 100%, meaning only your collateral of $1,332.10 remains. A stop-out occurs when 10% of the collateral is left ($133.2). So, you are left with $1,332.10 – $133.2 = $1,198.90. That means only 119 points remain before a stop-out. In reality, the stop-out would occur at a drawdown of 866 + 119 = 985 points. After the stop-out, $133.2 remains on the trading account.
As we can see, with a leverage of 1:100 and 1:500, the difference before a stop-out is 997 – 985 = 12 points. If you occasionally trade a lot of 1 unit with a deposit of $1,000–$3,000, you will always end up in the list of losers because this is a clear risk violation, and reducing leverage from 1:500 to even 1:5 won’t help.
Throughout the time the position remains open, the broker will hold the margin (as collateral), preventing new positions from being opened with that amount. The question arises: what should you do if you want to open multiple trades simultaneously? Then you will need either a larger amount of funds on the trading account or a higher leverage.
It doesn’t matter which market you plan to use leverage on; the key is to understand what it affects. As many believe, using high leverage can lead to significant losses. In this case, we don’t recommend increasing volumes without limits or allowing equity to decline by more than 10-20% of the deposit, let alone reaching a stop-out.
Why Use High Leverage?
- You always have more free funds, allowing you to activate a new trading system on your current account.
- With different trading systems, you have options to work with both constant and variable volumes depending on the signal type or presence/absence of drawdowns. This may result in a situation where 99% of the time you need just 1 lot of open positions, but in 1% of the time, the volume could be 20 lots to preserve growing equity.
- In portfolio management, maximum leverage is always relevant, as a properly formed portfolio ensures continuous equity growth. Reducing leverage leads to lower returns due to the inability to place maximum volumes during the exit from a drawdown.
The higher the leverage, the more free funds you have. It is high leverage that allows you to add more trading instruments to your investment portfolio, and each new instrument or trading system reduces the overall portfolio risks. After all, while one order is in a drawdown, another order generates profit. Of course, this requires knowing how to effectively diversify risks across the portfolio. Thus, the higher the leverage, the better the diversification works, and there is potential to increase overall profitability.
From an institutional perspective, high levels of leverage exist only on the foreign exchange market. Because of this, participants in other financial markets sometimes reject them, citing that with the start of market regulation, large leverage sizes will leave the trading conditions of Forex brokers. However, for example, Cypriot jurisdiction allows a maximum leverage of 1:500. And as we already found out in our calculations above, you can also trade with low leverage, the only limitation being the amount of free funds. Therefore, use today’s opportunities to trade to the fullest!
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“excerpt”: “Understanding leverage in forex trading, how it works, and how to choose the right leverage size. Learn about the key principles of margin trading.”,
“slug”: “high-leverage-vs-low-leverage-trading”,
“short_description”: “What is leverage in forex, how does it work, and how to choose the right leverage size? Detailed explanation of the key principle of margin trading.”,
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FAQ
What is leverage in trading?
Leverage is a tool that increases the funds a trader uses for opening and maintaining a position, allowing access to larger market exposure with a smaller capital investment.
How does leverage affect risk?
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