Today’s article is closely connected with the previous article on margin. The leverage is a topic that deserves a broader analysis, so we divide the article into two parts.
Leverage is the main reason why CFDs are so popular. We are allowed to trade big positions with small capital. But of course, it has its own pros and cons.
CFDs enable us to trade financial derivatives like forex, commodities or stocks in a simplified way, and we are able to use a financial leverage, which enables us to control a large position with a small account and to achieve higher valuation.
The financial leverage is selected by us when setting up the account at the broker. The broker can offer us several options of the financial leverage (see the table below). But be careful, it works on both sides. We can use it to make a higher gain, but we can also decrease our account by the same amount.
Formula to calculate the leverage size and margin
- You will trade 3 lots of EUR / USD with a leverage of 1: 200 on a dollar account.
- Position size: 300,000
- Current market price EURUSD: 1.13798
- Required margin: 300,000 / 200 * 1.13798 = $ 1706.97
Position size / Leverage size * Current market value = Margin
To better understand the pattern, I will also explain how the lot size is calculated.
|Lot size||Definition||Equivalent in USD|
|1||Standard lot||$100 000|
|0.10||Mini lot||$10 000|
|0.01||Micro lot||$1 000|
So, if we go for EURUSD, currently at 1.23500, with a size of 0.50 standard lot with a 100: 1 leverage, the formula will be as follows:
Now that you understood how lot and leverage work precisely, the table in the previous article becomes more clear. Example for EURUSD:
|Leverage||Position size 1 lot = 100 000 units||required margin|
|1:1||$100 000||100 000|
|2:1||$100 000||50 000|
|50:1||$100 000||2 000|
|100:1||$100 000||1 000|
If we trade a EURUSD currency pair, the margin will be in EUR. For the USDJPY currency pair, margin will be in the USD, for GBPUSD pair, margin will be in GBP. Margin of the currency pair will be always in the first currency of the pair. With the leverage 400: 1, the margin will be 250 EUR.
As you can see, the higher the leverage we have, the less margin we need (broker deposit). It’s not always good.
- If you start trading on the forex market, use a lower leverage. It will not allow you to open positions bigger than you should open.
- It’s nice to open with a small account bigger positions and it is even better when the market goes in our direction. That’s how it can works a couple of times, and we can gain on our account few dozen percent, but you’re creating a bad habit that can later cost you your entire trading account.
- If you are much influenced by your psyche during the trading, you should not use a high leverage at all. High levels of dopamine and euphoria during gaining period can be easily switched for frustration and anger in case the big loss occurs, and it will take a long time to recover.
- In the next work we will look at the leverage we really need and we will also check the risks associated with a different leverage.