Forex 102 – Understanding Leverage

Filed Under (Journal) by Casey on 16-12-2011

I have to admit, while I do understand what leverage is per say… One thing that I am still ignorant about is how leverage is going or can be used properly in Forex.

Especially for a guy who plays with Martingale strategy, leverage and margin are two important key… However, all I know is that I need high leverage and high margin in order for martingale to work but I never realize how it can work or will work towards my favor.

So in order for me to re-educate myself, I share with you what I leave, read and understand.

From Wikipedia Leverage
In finance, leverage (sometimes referred to as gearing in the United Kingdom) is a general term for any technique to multiply gains and losses.[1] Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives.[2] Important examples are:

  • A public corporation may leverage its equity by borrowing money. The more it borrows, the less equity capital it needs, so any profits or losses are shared among a smaller base and are proportionately larger as a result.[3]
  • A business entity can leverage its revenue by buying fixed assets. This will increase the proportion of fixed, as opposed to variable, costs, meaning that a change in revenue will result in a larger change in operating income.[4][5]
  • Hedge funds often leverage their assets by using derivatives. A fund might get any gains or losses on $20 million worth of crude oil by posting $1 million of cash as margin.[6]

It goes on to say that there are two different definition of leverage investing and corporate financing. But I guess we will go on to investing as it is more applicable to me.

Now taking it one step at a time, I shall go on to use wikipedia’s example on investing leverage because this has more to do with what I am doing in forex than corporate finance leveraging.

  • Buy $100 of crude oil. Assets are $100 ($100 of oil), there are no liabilities. Accounting leverage is 1 to 1. Notional amount is $100 ($100 of oil), there are no liabilities and there is $100 of equity. Notional leverage is 1 to 1. The volatility of the equity is equal to the volatility of oil, since oil is the only asset and you own the same amount as your equity, so economic leverage is 1 to 1.
  • Borrow $100 and buy $200 of crude oil. Assets are $200, liabilities are $100 so accounting leverage is 2 to 1. Notional amount is $200, equity is $100 so notional leverage is 2 to 1. The volatility of the position is twice the volatility of an unlevered position in the same assets, so economic leverage is 2 to 1.

I am going to take only the above two example to illustrate because I was pretty lost with the 3rd and 4th example.

So, it’s pretty simple. Borrow $500 and buy $600 worth of crude oil (using the example above) my leverage would be 5 to 1. So if my leverage is 500 to 1, it means I borrow $50,000 to by $50,100 worth of crude oil.

In very simple explanation in forex trading, leverage is borrowing money to trade/speculate.

They say leverage is important in ones trading activities. And if we were to choose an incorrect leverage it could result in large losses and damage potential profits.

That is what they say… but how is this so? I mean if I were to choose 500:1 leverage on my account, won’t it mean that I am borrowing money to trade… and my risk is just loosing my ‘upfront’ money or my margin.

So now we enter to an new term ‘margin’. Why do they call it margin? Why don’t they call it deposit? Or downpayment? Or collateral? Isn’t that what they call in the financial world when you want to borrow money from a financial institution?

But if I am not mistaken it’s one and the same. Margin is the money you are going to put up front.

So let me get this right…

If I were to trade 1 lot of EURUSD with a leverage of 100:1, it means I am buying 100,000 EUR (where 1 lot = 100,000 unit base currency)

Margin requirement is number of lots divided by leverage.

Which means my margin required is 1/100 = 0.01!! What the hell does it mean?!

Oh… my apologies… it is suppose to be unit base currency divide by leverage

* 100,000/100 = 1000EUR

So if I were to leverage on 500:1 it means

100,000/500 = 200EUR

Bwah!!! I only need to put in a collateral of 200EUR to trade 1 lot with a leverage of 500:1, while I need 1000EUR to trade 1 lot with a leverage of 100:! Isn’t that great?!

Let’s see how great leverage can be…

With 500:1 leverage I put in 200EUR to trade 1 lot and if I made 100EUR it means my return on my capital/deposit/collateral = 50%

With 100:1 leverage I put in 1000EUR to trade 1 lot and if I made 100EUR it means my return on my capital/deposit/collateral = 10%

Wow!! Great return isn’t it? But with every great return there is also a great lost… Let’s reverse the idea.

With 500:1 leverage I put in 200EUR to trade 1 lot and if I lose 100EUR it means my lost on my capital/deposit/collateral = 50%

With 100:1 leverage I put in 1000EUR to trade 1 lot and if I lose 100EUR it means my lost on my capital/deposit/collateral = 10%

Awww… not that is not such a great picture anymore.

As they say… leverage is a double edge sword. It slice you the same way as it slice others…

So how does this apply to my martingale play?

With martingale, I need a huge of amount of money to withstand the deep drawdown when my trade begins to increase in a martingale steps. That is where high leverage comes in. Nothing more.

If I were to take an example of 5 steps martingale it would be as such 1, 2, 4, 8, 16 = 31 units, which means I need enough money to hold 31 units. If it was lots than I need money to hold 31 lots. That is why to trade martingale or ever grid strategy I need very high leverage.

For Lovely Megan, the maximum leverage I use with FXOpen is 500:1 on 1000USD. On top of that, I trade the smallest lot available to me. 0.1 lot on a micro account is nano lots.

To digress I found out that there are some brokers offering pico lots… which is 0.01 lot on a micro account. That is earning peanuts. Sorry… it’s even smaller than peanuts. Probably a speck of sand.

With martingale, leveraging highly is not a double edge sword anymore. It’s more of a single side saber because my returns is in steps, small baby steps. While there is only one downside. DOWN!

If one were to play with martingale, it has to be for fun because the upside is slow and steady. While the downside is fast and crumbling…

But if it is not a martingale system then will taking a high leverage serve my purpose?

I think it depends on what we what we want to achieve. High leverage means high return on capital but it also means high loses.

Ok… so now I have a better understanding of leverage. I know why and how to use leverage on my martingale strategy. My next question is how to use leverage on my other strategy?

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