The Forex market is known for having specific characteristics different from other markets, such as its excellent liquidity, hours (it opens from Monday to Friday without interruption), and leverage.
We can operate with up to 1:500 leverage in the Forex market, depending on the broker. This means that for every dollar we have in our account, we can move 500 dollars in the market.
What is leverage?
Leverage is the relationship between equity and credit for those who don’t know yet. In other words: it is using debt, getting into debt, to finance a financial operation and obtain a higher return if the operation is successful. The more leverage, the greater the risk in our operations.
Advantages and disadvantages of leverage
Leverage has good things and bad things, like everything in life. As the main advantage, leverage allows us to grow our account more quickly as long as we manage it well. The main drawback of leverage is the risk of having high leverage without good leverage management.
What happens if we get too leveraged?
Well, we will be risking a lot for each operation (always assuming that the distance to the stop is the same and we only vary our leverage). In a few operations, we are going to decapitalize our account. Here asymmetric leverage comes into play, we could define asymmetric leverage as the progressive reduction of the ability to recover losses.
How do we calculate leverage in Forex?
First of all, it must be made clear that leverage is not a guarantee. The guarantees are the money the broker takes from our account when opening an operation. At the same time, leverage, as we have already explained before, is the relationship between own capital and credit.
And how do we calculate leverage? Very simple, dividing the face value of the operation that we have open, or operations that we have open if there is more than one, between our capital.
For example, let’s imagine that we have an account of €5,000 and that the total nominal amount of our operations in the Forex market is €100,000. The calculation would be as follows: leverage = (Nominal amount of operations)/(capital of our account) = 100,000/5,000 = 20. Our leverage would be 1:20. That is, for every euro that we take into account, we are moving 20 in the market.
And how do we know the nominal value of our Forex operation? For this, we will have to review some basic concepts of Forex trading. But in summary, with a lot, the face value of the operation is 100,000 monetary units of the base currency, with a mini-lot, the face value of the operation is 10,000 monetary units of the base currency. And with a micro-lot, the face value of the operation is 1,000 monetary units of the base currency.
Examples of asymmetric leverage
Let’s imagine that we have an account of €100, and in a trade, we have risked 1% of the account and lost it. That is, we have lost €1.
Now our account is €99 and to bring it back to €100 we have to earn 1.01% in the next operation, that is, what represents €1 out of €99, practically the same as what we have lost. But if instead of losing €1, we lose €10, 10% of the account, we will have to recover €10 out of €90, which is 11.11% of our current capital. And if we lose 25% of our account, we will have to earn 33.33% to bring it back to €100.
With a 2% risk per trade, we will need a 15-consecutive losing streak to pass this point. With a 3% risk, we will need a total of 10 consecutive losses to pass this point, and with a 10% risk per trade, we will pass this point with the third loss in a row.
This is an approximation to see what would happen if we go too far with the leverage since, in actual operations, monetary management would also come into play.
What is the optimal leverage?
There are many theories regarding this topic, and each has its own opinion about it for different tastes. In other words, there is no holy grail, there is no single truth.
Searching for information on this subject on the web, we found this post that the forum member Imarlo wrote a few years ago in which he comments on Lars Kestner’s formula, which gives an approximation of optimal leverage by dividing the average of the returns of an investment method or a trading system between their variance. If the average increases, the optimal leverage level will increase, and if the volatility (risk measure) increases, the optimal leverage level will decrease.
On the web, in books, or courses/seminars, we can find other approaches to calculate optimal leverage. Others recommend not exceeding leverage of 1:10, others leverage of 1:20. But as I said before, there is no optimal level of leverage. The best level of leverage will be the one with which we are comfortable and that, above all, does not make us decapitalize our account in the blink of an eye, especially in the Forex market.
In summary, leverage can help to obtain more benefits by trading. Still, you have to understand very well how it works and have it controlled at all times because, as we have explained before if we do not have control over it, it is straightforward to reach the point of no account return. This is why it is essential to practice with a demo account.
