How does leverage impact Forex Trading

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As stated at the beginning of this guide, off-exchange foreign currency trading carries a high level of risk and may not be suitable for all customers. The only funds that should ever be used to speculate in foreign currency trading, or any type of highly speculative investment, are funds that represent risk capital; in other words, funds you can afford to lose without affecting your financial situation.

Let’s proceed on the assumption that you have risk capital you would like to use in trading forex. The next question is how much you need to open an account. Forex dealers can set their own minimum account sizes, so you will have to ask the dealer how much money you must put up to begin trading.

Most dealers will also require you to have a certain amount of money in your account for each transaction. This security deposit, sometimes called margin, is a percentage of the transaction value and may be different for different currencies. Keep in mind that a security deposit acts as a performance bond and is not a down payment or partial payment for the transaction.

Let’s use an example of a dealer requiring a 1% security deposit. The formula for calculating the security deposit is:

The current price of the base currency X transaction size X security deposit % = security deposit requirement given in quote currency

Looking at the Euro example we used earlier, multiply the current price of the base currency ($1.2178) times the transaction size of 100,000 times 1%. Your security deposit would be $1,217.80.

$1.2178 X 100,000 X .01 = $1,217.80

Security deposits allow customers to control transactions with a value many times larger than the funds in their accounts. In the previous example, $1,217.80 would control $121,780 worth of Euros.

This ability to control a large amount of one currency using a very small percentage of its value is called leverage. In our example, the leverage is 100:1 because the security deposit controls Euros worth 100 times the amount of the deposit.

Since leverage allows you to control large amounts of currency for a very small amount, it magnifies the percentage amount of your profits and losses. A profit or loss of $1,217.80 on the euro transaction is 1% of the full price but is 100% of the 1% security deposit.

The higher the leverage, the more likely you are to lose your entire investment if exchange rates go down when you expect them to go up or go up when you expect them to go down. Leverage of 100:1 means that you will lose your security deposit when the currency loses or gains 1% of its value, and you will lose more than your security deposit if the currency loses or gains more than 1% of its value. If you want to keep the position open, you may have to deposit additional funds to maintain a 1% security deposit.

For example, assume you buy or sell a contract worth $100,000 and it moves against you by $2,000. No matter how much money you put up, your dollar loss will always be the same— $2,000—but the percentage loss varies with the amount of leverage. At 100:4 leverage, you will have lost half of your investment. At 100:2 leverage, you will have lost your entire investment. And at 100:1 leverage, you will have lost twice your investment and owe the dealer $1,000.

Notional value = $100,000
Loss = $2,000

Original Investment Leverage Remaining Funds Loss
$4,000 100:4 $2,000 50%
$2,000 100:2 $0 100%
$1,000 100:1 -$1,000 200%

You should check your Account Agreement with the dealer to see if the Agreement limits your losses. Some dealers guarantee that you will not lose more than you invest, which includes both the initial deposit and any subsequent deposits to keep the position open. Other dealers may charge you for losses that are greater than your investment.

Your Account Agreement with your dealer is crucial. Just as you wouldn’t consider buying a house or a car without carefully reading and understanding the terms of the sale, neither should you establish a forex account without first reading and understanding the Account Agreement and all other documents supplied by your dealer. You should know your rights and responsibilities, as well as the firm’s obligations before you enter into any forex transaction.

For example, if you are not willing or able to pay the full price and take delivery of the currency, make sure the Agreement gives you the right to enter into an offsetting transaction with the dealer. In other words, the Agreement should require the dealer to buy back any currencies you previously bought or to sell you any currencies you previously sold. Otherwise, you may be responsible for paying the value of the entire forex contract and accepting the foreign currency.

A number of firms are presently offering options on off-exchange foreign currency contracts. Buying and selling forex options present additional risks, many of which are similar to those inherent in buying options on exchange-traded futures contracts. NFA publishes a brochure called “Buying Options on Futures Contracts: A Guide to Their Uses and Risks” which discusses the mechanics and risks of options trading. The brochure can be downloaded from NFA’s Web site.

Most exchange-traded options can be exercised at any time before they expire. These are called American-style options. Many forex options are European-style options, which can be exercised only on or near the expiration date. In other words, you can’t take advantage of a favorable price move that occurs before the expiration date unless you can offset your position. You should understand which type of option you are purchasing.

Quiz 3

Q: If a forex dealer charges a 1% security deposit, how much will a speculator be required to post as a security deposit to trade an Australian dollar/US dollar spread if the speculator bought 1,250,000 Australian dollars at .7707 US dollars?

A. $7,707
B. $1,250
C. $9,634
D. $3,760

A: The correct answer is C.

The formula for calculating the security deposit required is the current price of the base currency times the transaction size times the security deposit percentage. In this case, the price of the base currency is $.7707. The transaction size is 1,250,000 and the security deposit percentage is 1%.

.7707 X 1,250,000 X .01 = 9,634 US dollars

Q: A 1% security deposit is what type of leverage?

A. 50:1
B. 100:1
C. 25:1
D. 10:1

A: The correct answer is B – 100:1

Q: In an account with a $100,000 position in Japanese yen with 100:1 leverage, what would be the impact of a $1,000 decline in the value of the position?

A. 10% loss
B. 50% loss
C. 100% loss
D. 25% loss

A: The correct answer is C.

In the case of a $100,000 position with 100:1 leverage, the customer would have been required to post a security deposit equal to 1% of the position value. In this case, the security deposit would have been $1,000 ($100,000 X .01). A 1,000 US dollar decline in the value of the position would have completely wiped out the security deposit.