In this guide we will talk about the leverage or leverage effect in Forex and more generally in online trading.
Notice: ESMA has significantly reduced the leverage for retail traders. From August 1, 2018 the maximum leverage values will be the following:
- 1:30 for major currency pairs, that is, those that include the US dollar, such as EUR / USD or GBP / USD.
- 1:20 for secondary currency pairs, that is, those that do not include the dollar, such as EUR / CHF; for gold and the most important stock indices in the world.
- 1:10 for all other commodities and stocks indices.
- 1:5 for stocks.
- 1:2 for currency, like Bitcoin.
Professional traders will instead continue to use any level of leverage offered by the chosen broker.
In this guide we will explain what leverage is in Forex, how it works and how to use it in online trading so as you don’t incur particular dangers. Let’s start from the definition, then move on to analyze its functioning, advantages and disadvantages, and the risks of this tool.
After all, all traders operating in the Forex or CFD market will have to deal with leverage. Knowing how leverage works is therefore a fundamental requirement for all those who want to start Forex trading or CFD trading.
Definition of financial leverage and leverage effect
So let’s start with what leverage is. It works much like a normal lever. Through a lever we can in fact lift much greater weights than ours. In other words, the lever allows us to have a greater force than what we really have.
Same thing happens with leverage in Forex and online trading. Thanks to this we can move capitals much higher thatn those we really have. Just to give you an example, thanks to the leverage effect, with only € 100 we can even move € 10,000! It looks like science fiction, but it isn’t: so let’s see how leverage is applied in trading.
How the financial leverage works in Forex and trading
Leverage is a fundamental component of Forex trading and CFD trading. Through it we can invest much larger amounts than what we really have. Leverage is expressed as this ratio: 1:10 or 1:100 and so on.
Using a 1:100 leverage means that for every € 1 we invest, thanks to the leverage effect we are actually moving € 100. Therefore, as we said in the previous example, with only € 100 and using a 1:100 leverage, we are able to invest € 10,000. The formula of leverage as we have just seen is quite simple, it is a multiplication.
The leverage ratios most used by professional traders are the following:
So if we use a 1:5 leverage it means that for every euro we will actually move five euros. While if we use a 1:200 leverage, due to the leverage effect for each euro we will move € 200. The leverage is offered by the broker you registered with (for Forex trading or CFD trading). For this reason, it is not said that you can find all the levers listed above. Depending on the broker, the financial leverages available may vary.
We always remember that retail investors have a limit established by the new ESMA regulation, while professional traders can use all the financial levers offered by the broker.
It is probably that, at this point, you are asking yourself this question: but if with only € 1 I can even move € 200, from where do the other € 199 pop up? To answer this, we need to introduce the concept of margin.
Financial leverage and margin
Margin is a concept closely related to leverage. To use leverage, your broker will ask you for a small percentage of the total investment to be deposited as a “guarantee”. This amount varies depending on the money you are going to invest, as well as depending on the leverage you will use.
This amount is called margin and must be paid to the broker when you want to open a position using leverage. For example, always taking advantage of the previous example: if with € 100 we want to use a 1:100 leverage that allows us to invest € 10,000, the margin is equal to 1% (i.e. the € 100 that we are actually investing).
Margin in % = 100/leverage ratio
So if we want to use a 1:100 leverage and move a capital of € 50,000, we should pay the broker a margin equal to 1% of the total capital (the € 50,000 obtained through leverage). That is, we would need € 500 to open our position of € 50,000.
Risks and advantages of the financial leverage
Now that we understand what leverage is and how it is used, we need to focus on the risks and benefits of the leverage effect. The advantages are the first things we see: thanks to leverage, we can invest more capital than we have. With just € 1,000 and a 1:100 leverage, we can also invest € 100,000.
Obviously the earnings are calculated precisely on the amount we move through the leverage (therefore on € 100,000) and not on the margin that we actually pay to the broker to use the leverage (and to borrow the money necessary to open our position). So through leverage we can amplify our earnings. And also a lot.
It would be really nice if the leverage was limited only to amplifying earnings. Too bad, however, that the leverage effect also amplifies losses. As we have told you, what matters is not the margin that we pay to the broker. Rather, it is the amount we move through leverage. All losses and gains are therefore calculated on this amount and not on the margin.
This means that even small variations in the value of an asset allow us to get excellent profits; but at the same time, small changes in the wrong direction can burn all the capital we paid to the broker (the margin). Let’s better understand the leverage and the risk of the leverage effect through a quick example of CFD trading.
Financial leverage in Forex and CFD trading
Let’s assume we use a 1:10 leverage to do CFD trading. This allows us to trade with different types of assets, like:
- stock indices
- currency pairs
We choose stocks because, according to our analyzes, the stock of X company is expected to rise in the next few days. The current value of the stock of company X is € 3.00. Let’s say we want to buy 1000 shares of X company.
In the classic stock market, in order to buy 1000 shares of X company, we would have to pay € 3000 (single share price multiplied by the quantity of shares we want to buy). If the price of the shares increases and reaches € 3.30, we would have a gain of € 300, given that if we were to resell the shares now we would collect € 3300 (and we had spent € 3000 to buy them: therefore the difference is equal to our earning).
Let’s see what happens if we use CFD trading and therefore leverage. If we choose 1:10 leverage, we have to pay a margin equal to 10% of our position (i.e. the total amount that we will move with leverage). Buying 1000 shares of X company is that same as paying out € 3000: but through leverage, we can pay € 300 to our broker as margin and move a capital of € 3000.
Also in this case, if the value increases to € 3.30 per share, we would always get € 300 in earnings. We therefore obtained a return equal to 100% of our investment, when with the stock market we would have obtained a return equal to 10%.
The difference is as follows:
- in the stock market, we had to invest € 3000 to open our position of 1000 shares of the X company;
- in the CFD market, we had to invest € 300 (the margin) to open our position of 1000 shares of the X company.
But remember that leverage also amplifies your losses. If the price had gone down 30 cents instead of going up, we would have lost € 300. In the case of the stock market, it’s equal to only 10% of our initial investment (which was € 3000). But in the case of CFD trading, it equals 100% of our investment (€ 300): we would therefore have lost all our capital.
Trading with financial leverage: brokers that offer the best financial leverage
If you are going to use leverage in online trading, you are now aware of its advantages, as well as its risks. Leverage can be an excellent ally for any trader, as long as you use it without exaggerating. For example, if you only have € 1000 on your trading account, and choose a 1:200 leverage going to move € 200.000 to invest on a certain asset, the risk you will run is very high.
Leverage effect on eToro
The leverage you use must always be related to your available capital. For this reason, it is important to choose a broker that offers different financial leverages, to be sure of finding the one that suits your situation.
The eToro CFD broker, a leading broker in the social trading sector, offers flexible and advantageous leverages for its customers. Social trading is a new way of trading online, where it is possible to automatically follow and copy the operations of other traders (including professionals in the sector).
Regarding the leverage effect offered by the eToro broker for CFD trading on its platform:
- Currency pairs: Minimum leverage 1:2 / Maximum leverage 1:400
- Commodities: Minimum leverage 1:2 / Maximum leverage 1:100
- Stock indices: Minimum leverage 1:2 / Maximum leverage 1:100
- Stocks: Minimum leverage 1:1 / Maximum leverage 1:5
Leverage effect on Plus500
Another well-known CFD broker is Plus500, one of the first brokers to open their doors online. He was one of the first CFD brokers to offer a free demo account from the start for all his clients and for all those who wanted to try the Plus500 trading platform without opening a real account.
It is a broker regulated by CySec, the British FCA and also by the Australian ASIC. The Plus500 broker offers a completely web-based trading platform (so you don’t have to download anything to your computer), and also a free demo account to practice.
If you are a retail trader, the limits imposed by ESMA are the following: 1:30 for the main currency pairs, i.e. those that include the US dollar, such as EUR / USD or GBP / USD. 1:20 for for secondary currency pairs, i.e. those that do not include the dollar, such as EUR / CHF; for gold and the world’s leading stock indices. 1:10 for all other commodities and secondary stock indices. 1:5 for stocks. 1:2 for cryptocurrencies, such as Bitcoin.
Professional traders can operate with a higher leverage, the maximum one offered by the broker.
Leverage is a double edged sword, in fact it increases not only gains, but also losses. Take this factor into consideration when investing.