What is leverage in forex trading?

Using leverage in trading can be a risky endeavour that has its pros and cons. When used wisely and combined with effective risk management strategies, leverage can offer significant advantages. However, if used recklessly, it can turn into a dangerous weapon that can magnify losses when trades go south. In this article, we’ll explore the concept of leverage in forex trading, looking closely at how it works and carefully evaluating its benefits and potential drawbacks.

What is leverage in forex trading?

In forex trading, leverage refers to the practice of using borrowed capital to increase the potential returns on an investment. It allows forex traders to open positions that surpass the amount of money available in their accounts by borrowing additional funds from their broker. This approach enables traders to engage in larger trades and potentially achieve higher profits than they would with only their own capital.

For example, a trader with £1,000 in their account who wishes to open a £30,000 position can use leverage to do so by obtaining a loan of £29,000 from their broker. The trader would then only have to provide a small percentage of the trade value as collateral, known as the margin.

Leverage offers traders the opportunity to potentially amplify their profits, but it also heightens the risk of losses. If a trade goes against the trader, they may need to close their position or deposit additional collateral to sustain it, potentially leading to substantial losses.

Here are some risks of using leverage in forex trading:

Increased risk of losses: If a trader decides to open a substantial position, risking more than 5%, and the trade goes against them, they may be compelled to either close the position or inject additional collateral to sustain it. Such a situation can result in significant losses, particularly if the trader has overextended their risk exposure.

Margin calls: When the value of a trader’s account falls below the required margin level, the broker may issue a margin call, which requires the trader to add additional collateral to their account to maintain their open positions. If the trader is unable to meet the margin call, their positions may be closed automatically, resulting in additional losses.

Risk of liquidation: If the market moves against a trader using leverage and the trader is unable to add additional collateral to their account, their positions may be liquidated automatically to pay off any outstanding debts to the broker. This can result in significant losses for the trader.

Volatility: Leverage can amplify the effects of market volatility, which can result in rapid price movements that may be difficult to predict or manage.

Risk of overtrading: Leverage can make it easier for traders to open large positions, which can increase the temptation to overtrade, or trade too frequently, which can lead to increased risk and potential losses.

Despite the high risks associated with trading leverage, if traders skillfully manage their risk and refrain from overexposing themselves through excessively large positions, leverage can potentially work in their favour.

What is the maximum leverage limit in the UK?

The maximum leverage that can be offered to retail traders by forex brokers in the United Kingdom is currently 30:1. This means that traders can open positions up to 30 times the size of their capital.

The maximum leverage allowed for forex trading in the UK is set by the Financial Conduct Authority (FCA), the regulatory body that oversees the financial services industry in the country. The FCA implemented these leverage limits after the 2015 SNB black swan scandal to protect retail traders from excessive risk-taking and to reduce the potential for losses.