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Calculating Leverage in Forex Review

The concept of leverage is really quite simple, but its true meaning often becomes lost in the mountain of marketing-speak most forex brokers dish out at us traders. The misconceptions always arise as a result of the interchangeable usage of the words “margin” and “leverage”. These two concepts are related, but are in fact not interchangeable except in the most extreme (and suicidal) case where a trader decides to use the maximum leverage available to him under the broker’s house rules.

 

Margin - The amount of collateral a customer deposits with a broker when borrowing from the broker to buy securities. This is your account balance when you first open your account.

 

Leverage* - The use of credit or borrowed funds to increase one's speculative capacity and increase the rate of return from an investment, as in buying securities on margin, although it can also increase the rate of loss by the same factor. Your leverage depends on the size of the trades you make relative to your account equity, and nothing else, as long as you don’t surpass the maximum leverage the broker allows. This value is normally displayed as a DEBT:EQUITY ratio.

 

Margin requirement – expressed as a percentage, the margin requirement is set by your broker to protect itself against traders using too much leverage, or in other words, against traders borrowing more than their collateral would support according to the broker’s risk management parameters.

 

* This definition applies to trading accounts. The more general definition of financial leverage is somewhat more complicated, but luckily it is unnecessary for our current purposes.

 

So when a broker’s marketing team says their margin requirement is 1%, it means that they require 1% of your trade size in order to lend you the amount you need for the trade. For example if you are trading $100,000 position size, then the broker requires $1,000 (1%) of your margin in order to make the loan. As I stated before, this number generally does not vary unless you specifically change the deal with your broker. Furthermore, in this example we know what the margin requirement is, but we don’t yet have enough information to calculate leverage, because we don’t know what our account equity is (more about this later). Your broker would normally quote that as “100:1” leverage, which is not entirely accurate since our actual leverage also depends on our account equity. What they are actually saying is that your maximum leverage, based on their margin requirement, would be 100:1. How much of that leverage you actually use is entirely up to you, as long as you don’t surpass this maximum.

 

To recap then, the major difference is that the margin requirement is set by your broker, which determines your maximum leverage. How much of that available leverage you use in your trades is entirely your choice. Your broker does not set your leverage. They just set the maximum that you can use. A responsible trader generally never has to worry about this, as the leverage s/he uses is far below the maximum allowed by the broker. Whether a broker’s marketing guys offer you “400:1 leverage” or “50:1 leverage” should not generally make any difference. Let’s see first how to calculate leverage, and then why responsible traders never over-use it.


 

How to calculate “true” leverage

 

The term “true” leverage has been in use recently to differentiate it from the “maximum” leverage that brokers use in their marketing efforts. A few years ago, the word “leverage” would have been sufficient to describe what we are calculating, but retail forex marketing lingo has changed the traditional use of the word.

 

As we mentioned before, leverage in the financial markets is the DEBT:EQUITY ratio, so we need to calculate our debt and our equity (duh).

 

Equity is very easy to calculate:

 

E=B+P

 

where

E = Equity (the quantity we are trying to calculate)

B = Balance

P = Profit on open positions (negative if open positions are in the red)

 

Debt is a little more complicated:

 

                                                          debt equation*

 

Where

D = Debt (the quantity we are trying to calculate)

T = Trade size (in units of the base currency)

CB = Base currency

CA = Account currency

 

* Please note that the equation uses forex notation, and not true mathematical notation. In mathematical notation, EUR/USD would be displayed as USD/EUR because it denotes a ratio of “Dollars per Euro”. If you would like to use mathematical notation, currency pairs should be inverted.

 

So leverage, L, is calculated as follows:

 

                                                            leverage equation

 

 

If that looks complicated, please don’t worry, it isn’t. Let’s work through an example:

 

Say you have a $10,000 USD-denominated account and you wish to trade 1 mini lot of EUR/USD at 1.2500:

 

                                                      leverage example

 

T = 10,000 (1 mini lot)

EUR/USD = 1.2500

B = $10,000

P = 0 (we don’t have any trades open so the account equity is equal to the account balance)

 

Substituting in the values:

 

                                             leverage example result

 

 

These calculations ignore the spread, which would affect P. Equations for that become more complicated because we have to include the pip value. In this example, it would be simple, but for pairs where the quote currency is not the same as the account currency, our leverage equation would be significantly more complex. This omission only becomes significant for large values of P relative to B (positive or negative) which should not generally occur in a properly managed forex account.

 

Please note also that this formula works equally well for pairs which do not involve the account currency, but we have to be careful to make the right substitution, and we need a bit of extra information. For example, say we are trading 1 mini lot of GBP/JPY = 200.00 and GBP/USD = 2.0000 on the same $10,000 account:

 

                                                 cross example

 

 

For trading such pairs, we need to know the current rate of the base currency against the account currency, and we don’t need the rate for the actual currency we are trading:

 

                                                 not leverage

 

 

It also needs to be noted that the actual leverage used varies during the lifetime of any open trade. As currency rates move, they affect the leverage equation by affecting P as they either move in your favor or against you, and they also affect Cb/Ca.

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