Forex Leverage. What should I use?

One of the reasons why so many people are attracted to trading forex compared to other financial instruments is that with forex, you can usually get much higher leverage than you would with stocks. While many traders have heard of the word "leverage," few have a clue about what leverage is, how leverage works and how leverage can directly impact their bottom line.

SEE: How does leverage work in the forex market? 

What Is leverage?
Leverage involves borrowing a certain amount of the money needed to invest in something. In the case of forex, that money is usually borrowed from a broker. Forex trading does offer high leverage in the sense that for an initial margin requirement, a trader can build up - and control - a huge amount of money.

To calculate margin-based leverage, divide the total transaction value by the amount of margin you are required to put up.


Margin-Based Leverage =
Total Value of Transaction
Margin Required

For example, if you are required to deposit 1% of the total transaction value as margin and you intend to trade one standard lot of USD/CHF, which is equivalent to US$100,000, the margin required would be US$1,000. Thus, your margin-based leverage will be 100:1 (100,000/1,000). For a margin requirement of just 0.25%, the margin-based leverage will be 400:1, using the same formula.

Margin-Based Leverage Expressed as Ratio Margin Required of Total Transaction Value
400:1 0.25%
200:1 0.50%
100:1 1.00%
50:1 2.00%

However, margin-based leverage does not necessarily affect one's risks. Whether a trader is required to put up 1 or 2% of the transaction value as margin may not influence his or her profits or losses. This is because the investor can always attribute more than the required margin for any position. What you need to look at is the real leverage, not margin-based leverage.

To calculate the real leverage you are currently using, simply divide the total face value of your open positions by your trading capital.


Real Leverage =
Total Value of Transaction
Total Trading Capital

For example, if you have $10,000 in your account, and you open a $100,000 position (which is equivalent to one standard lot), you will be trading with a 10 times leverage on your account (100,000/10,000). If you trade two standard lots, which is worth $200,000 in face value with $10,000 in your account, then your leverage on the account is 20 times (200,000/10,000).

This also means that the margin-based leverage is equal to the maximum real leverage a trader can use. And since most traders do not use their entire accounts as margin for each of their trades, their real leverage tends to differ from their margin-based leverage.

Leverage in Forex Trading
In trading, we monitor the currency movements in pips, which is the smallest change in currency price, and that could be in the second or fourth decimal place of a price, depending on the currency pair. However, these movements are really just fractions of a cent. For example, when a currency pair like the GBP/USD moves 100 pips from 1.9500 to 1.9600, that is just a one cent move of the exchange rate.

This is why currency transactions must be carried out in big amounts, allowing these minute price movements to be translated into decent profits when magnified through the use of leverage. When you deal with a large amount like $100,000, small changes in the price of the currency can result in significant profits or losses.

When trading forex, you are given the freedom and flexibility to select your real leverage amount based on your trading style, personality and money management preferences.

Risk of Excessive Real Leverage
Real leverage has the potential to enlarge your profits or losses by the same magnitude. The greater the amount of leverage on capital you apply, the higher the risk that you will assume. Note that this risk is not necessarily related to margin-based leverage although it can influence if a trader is not careful.

Let's illustrate this point with an example (See Figure 1).

Both Trader A and Trader B have a trading capital of US$10,000, and they trade with a broker that requires a 1% margin deposit. After doing some analysis, both of them agree that USD/JPY is hitting a top and should fall in value. Therefore, both of them short the USD/JPY at 120.

Trader A chooses to apply 50 times real leverage on this trade by shorting US$500,000 worth of USD/JPY (50 x $10,000) based on his $10,000 trading capital. Because USD/JPY stands at 120, one pip of USD/JPY for one standard lot is worth approximately US$8.30, so one pip of USD/JPY for five standard lots is worth approximately US$41.50. If USD/JPY rises to 121, Trader A will lose 100 pips on this trade, which is equivalent to a loss of US$4,150. This single loss will represent a whopping 41.5% of his total trading capital.

Trader B is a more careful trader and decides to apply five times real leverage on this trade by shorting US$50,000 worth of USD/JPY (5 x $10,000) based on his $10,000 trading capital. That $50,000 worth of USD/JPY equals to just one-half of one standard lot. If USD/JPY rises to 121, Trader B will lose 100 pips on this trade, which is equivalent to a loss of $415. This single loss represents 4.15% of his total trading capital.

Refer to the chart below to see how the trading accounts of these two traders compare after the 100-pip loss.

Trader A Trader B
Trading Capital $10,000 $10,000
Real Leverage Used 50 times 5 times
Total Value of Transaction $500,000 $50,000
In the Case of a 100-Pip Loss -$4,150 -$415
% Loss of Trading Capital 41.5% 4.15%
% of Trading Capital Remaining 58.5% 95.8%
Figure 1: All figures in U.S. dollars

The Bottom Line
With a smaller amount of real leverage applied on each trade, you can afford to give your trade more breathing room by setting a wider but reasonable stop and avoiding risking too much of your money. A highly leveraged trade can quickly deplete your trading account if it goes against you, as you will rack up greater losses due to bigger lot sizes. Keep in mind that leverage is totally flexible and customizable to each trader's needs. Having an aim of trading profitably is not about making your millions by the end of this month or this year.


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What Can We Expect in Q4

October marks the beginning of the calendar fourth quarter. Investors have been on a wild ride in 2018, but U.S. stocks have performed well overall. However, a lot could change in three months time.

Key Themes

Russell Investments recently outlined what it sees as the key themes and catalysts for investors to watch in Q4. At the top of the list of market themes are the international trade wars, the U.S. Federal Reserve, China’s economic stimulus and the strength of the U.S. dollar. Russell said in its outlook there's a low risk of a U.S. recession, and Europe also appears poised for improving growth.

China and other emerging markets have been major weak spots in recent months. Russell said EM stocks are oversold, but the ongoing trade war may prevent a bounce-back in the near-term.

U.S. Earnings Slowdown

The U.S. economy is firing on all cylinders, but Russell said the 9-percent year-to-date rally in the S&P 500 is finally triggering some overbought indicators in the U.S. market. In addition, Russell said U.S. companies have an exceedingly high bar to clear to beat earnings expectations in the third and fourth quarters. At the same time, borrowing costs and wages are marching steadily higher, creating an earnings headwind.

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Other Asset Classes

For the first time in a long time, Russell said fixed income investments are starting to look appealing as well, especially the 10-year U.S. Treasury rate of around 3 percent.

On the currency front, Russell said there will likely be more upward pressure on the U.S. dollar in 2019, but the Japanese yen is currently 20 percent undervalued relative to purchasing power parity.

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Forex is short for foreign exchange, but the actual asset class we are referring to is currencies. Foreign exchange is the act of changing one country's currency into another country's currency for a variety of reasons, usually for tourism or commerce. Due to the fact that business is global, there is a need to transact with other countries in their own particular currency.

After the accord at Bretton Woods in 1971, when currencies were allowed to float freely against one another, the values of individual currencies have varied, which has given rise to the need for foreign exchange services. This service has been taken up by commercial and investment banks on behalf of their clients, but it has simultaneously provided a speculative environment for trading one currency against another using the internet.

Forex as a Hedge

Commercial enterprises doing business in foreign countries are at risk due to fluctuations in the currency value when they have to buy or sell goods or services to another country. Hence, the foreign exchange markets provide a way to hedge the risk by fixing a rate at which the transaction will be concluded at some time in the future.

To accomplish this, a trader can buy or sell currencies in the forward or swap markets, at which time the bank will lock in a rate so that the trader knows the exact exchange rate in order to mitigate his or her company's risk. To some extent, the futures market can also offer a means to hedge currency risk, depending on the size of the trade and the actual currency involved. The futures market is conducted in a centralized exchange and is less liquid than the forward markets, which are decentralized and exist within the interbank system throughout the world.

Forex as Speculation

Since there is constant fluctuation between the currency values of countries due to varying supply and demand factors such as interest rates, trade flows, tourism, economic strength and geopolitical risk, an opportunity exists to bet against these changing values by buying or selling one currency against another in the hopes that the currency you buy will gain in strength or that the currency you sell will weaken against its counterpart. (For additional reading, see "Top 6 Questions About Currency Trading.")

Currency as an Asset Class

There are two distinct features to currency as an asset class:

Why We Can Trade Currencies

Until the advent of the internet, currency trading was limited to interbank activity on behalf of their clients. Gradually, the banks themselves set up proprietary desks to trade for their own accounts, which was followed by large multinational corporations, hedge funds and high net worth individuals.

With help from the internet, a retail market aimed at individual traders has emerged, providing easy access to the foreign exchange markets, either through the banks themselves or brokers making a secondary market. (For more on the basics of forex, check out "8 Basic Forex Market Concepts.")

Forex Trading Risks

Trading currencies can cause some confusion related to risk due to its complexities. Much has been said about the interbank market being unregulated and therefore very risky due to a lack of oversight. This perception is not entirely true, though. A better approach to the discussion of risk would be to understand the differences between a decentralized market versus a centralized marketand then determine where regulation would be appropriate.

The interbank market is made up of several banks trading with each other around the world. The banks themselves have to determine and accept sovereign risk and credit risk, and for this they have many internal auditing processes to keep them as safe as possible. The regulations are industry- imposed for the sake and protection of each participating bank.

Since the market is made by each of the participating banks providing offers and bids for a particular currency, the market pricing mechanism is derived from supply and demand. Due to the huge flows within the system, it is almost impossible for any one rogue trader to influence the price of a currency. In today's high-volume market, with between $2 trillion and $3 trillion being traded per day, even the central banks cannot move the market for any length of time without the full coordination and cooperation of other central banks. (For more on the interbank system, read "The Foreign Exchange Interbank Market.")

Attempts are being made to create an Electronic Communication Network (ECN) to bring buyers and sellers into a centralized exchange so that pricing can be more transparent. This is a positive move for retail traders who will gain a benefit by seeing more competitive pricing and centralized liquidity. Banks of course do not have this issue and can, therefore, remain decentralized.

Traders with direct access to the forex banks are also less exposed than those retail traders who deal with relatively small and unregulated forex brokers, which can (and sometimes do) re-quote prices and even trade against their own customers. It seems that the discussion of regulation has arisen because of the need to protect the unsophisticated retail trader who has been led to believe that forex trading is a surefire profit-making scheme. (See also "Why It's Important to Regulate Foreign Exchange.")

For the serious and educated retail trader, there is now the opportunity to open accounts at many of the major banks or the larger, more liquid brokers. As with any financial investment, it pays to remember the caveat emptor rule – "buyer beware!" (For more on the ECN and other exchanges, check out "Getting to Know the Stock Exchanges.")

Pros and Potential Cons of Trading Forex

If you intend to trade currencies, in addition to the previous comments regarding broker risk, the pros and potential cons of trading forex are laid out as follows:

Pro: The forex markets are the largest in terms of volume traded in the world and therefore offer the most liquidity, thus making it easy to enter and exit a position in any of the major currencies within a fraction of a second.

Potential Con: As a result of the liquidity and ease that a trader can enter or exit a trade, banks and/or brokers offer leverage, which means that a trader can control quite large positions with relatively little money of their own. Leverage in the range of 100:1 is a high ratio, but not uncommon. Of course, a trader must understand the use of leverage and the risks that leverage can impose on an account. Leverage has to be used judiciously and cautiously if it is to provide any benefits. A lack of understanding or wisdom in this regard can easily wipe out a trader's account. (For more on leverage, check out "Forex Leverage: A Double-Edged Sword.")

Pro: Another advantage of the forex markets is the fact that they trade 24 hours around the clock, starting each day in Australia and ending in New York. The major centers are Sydney, Hong Kong, Singapore, Tokyo, Frankfurt, Paris, London and New York.

Potential Con: Trading currencies is a "macroeconomic" endeavor. A currency trader needs to have a big-picture understanding of the economies of the various countries and their inter-connectedness in order to grasp the fundamentals that drive currency values. For some, it is easier to focus on economic activity to make trading decisions than to understand the nuances and often closed environments that exist in the stock and futures markets where microeconomic activities need to be understood. However, an understanding of a company's management skills, financial strengths, market opportunities and industry-specific knowledge are not necessary in forex trading. (Take a look at "Economic Factors That Affect the Forex Market" to learn more.)

[Note: One of the underlying tenets of technical analysis is that historical price action predicts future price action. Since the forex market is a 24-hour market, there tends to be a large amount of data that can be used to gauge future price movements. This makes it the perfect market for traders that use technical tools. If you want to learn more about technical analysis from one of the world's most widely followed technical analysts, check out Investopedia Academy's Technical Analysis course.]

Two Ways to Approach Forex Trading

For most investors or traders with stock market experience, there has to be a shift in attitude to transition into or add currencies as a further opportunity for diversification.

1. Currency trading has been promoted as an "active trader's" opportunity. This type of opportunity suits brokers because it means they earn more due to the nimbleness that accompanies active trading.

2. Currency trading is also promoted as leveraged trading, and therefore, it is easier for a trader to open an account with a small amount of money than is necessary for trading in the stock market.

Besides trading for a profit or yield, currency trading can be used to hedge a stock portfolio. For example, if someone builds a stock portfolio in a country where there is potential for the stock to increase in value, but there is downside risk in terms of the currency (i.e., the U.S. in recent history), a trader could own the stock portfolio and short the dollar against another currency such as the Swiss franc or euro. In this way, the portfolio value will increase, and the negative effect of the declining dollar will be offset. This is true for those investors outside the U.S. who will eventually repatriate profits back to their own currencies. (For a better understanding of risk, read "Understanding Forex Risk Management.") Opening a forex account and day trading or swing trading is most common with this profile in mind.

A second approach to trading currencies is to understand the fundamentals and the long-term benefits. It is beneficial to a trader when a currency is trending in a specific direction and offering a positive interest differential that provides a return on the investment plus an appreciation in currency value. This type of trade is known as a "carry trade." For example, a trader can buy the Australian dollar against the Japanese yen. If the Japanese interest rate is .05% and the Australian interest rate is 4.75%, a trader can earn 4%. (For more, read "The Fundamentals of Forex Fundamentals.")

However, if the Australian dollar is strengthening against the yen, it is appropriate to buy the AUD/JPY and to hold it in order to gain in both the currency appreciation and the interest yield.

The Bottom Line

For traders – especially those with limited funds – day trading or swing trading in small amounts can be a good way to play the forex markets. For those with longer-term horizons and larger fund pools, a carry trade may be an appropriate alternative.

In both cases, traders must know how to map out the timing their trades through charts, since good timing is the essence of profitable trading. In both cases, as in all other trading activities, the trader must know their own personality traits well enough so that they do not violate good trading habits with bad and impulsive behavior patterns. (To determine what type of trading is best for you, see "What Type of Forex Trader Are You?")

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What is Forex?

Forex (FX) is the market in which currencies are traded. The forex market is the largest, most liquid market in the world, with average traded values that can be trillions of dollars per day. It includes all of the currencies in the world.

BREAKING DOWN 'Forex - FX'

There is no central marketplace for currency exchange; trade is conducted over the counter. The forex market is open 24 hours a day, five days a week, except for holidays, and currencies are traded worldwide.

The forex is the largest market in the world in terms of the total cash value traded, and any person, firm or country may participate in this market.

The Basics of Forex

The term foreign exchange is usually abbreviated as "forex" and occasionally as "FX."

The global foreign exchange market is the largest and the most liquid financial market in the world, with average daily volumes in the trillions of dollars. Forex transactions take place on either a spot or a forward basis. There is no centralized market for forex transactions, which are executed over the counter and around the clock. The largest foreign exchange markets are located in major financial centers like London, New York, Singapore, Tokyo, Frankfurt, Hong Kong and Sydney.

Just How Large Is the Forex Market?

The forex market is unique for several reasons, mainly because of its size. Trading volume is generally very large. As an example, trading in foreign exchange markets averaged $5.1 trillion per day in April 2016, according to the Bank for International Settlements, which is owned by 60 central banks, and is used to work in monetary and financial responsibility. 

The world's largest trading centers can be found in London, New York, Singapore and Tokyo. 

How to Trade in the Forex Market

The market is open 24 hours a day, five days a week across major financial centers across the globe. This means that you can buy or sell currencies at any time during the day.  

The foreign exchange market isn't exactly a one-stop shop. There are a whole variety of different avenues that an investor can go through in order to execute forex trades. You can go through different dealers or through different financial centers, which use a host of electronic networks

From a historic standpoint, foreign exchange was once a concept for governments, large companies and hedge funds. But in today's world, trading currencies is as easy as a click of a mouse — accessibility is not an issue, which means anyone can do it. In fact, many investment firms offer the chance for individuals to open accounts and to trade currencies however and whenever they choose. 

When trading in the forex market, you're buying or selling the currency of a particular country. But there's no physical exchange of money from one party to another. That's what happens at a foreign exchange kiosk — think of a tourist visiting Times Square in New York City from Japan. He may be converting his (physical) yen to actual U.S. dollar cash (and may be charged a commission fee to do so) so he can spend his money while he's traveling. But in the world of electronic markets, traders are usually taking a position in a specific currency, with the hope that there will be some upward movement and strength in the currency they're buying (or weakness if they're selling) so they can make a profit. 

Spot Transactions

A spot deal is for immediate delivery, which is defined as two business days for most currency pairs. The major exception is the purchase or sale of U.S. dollars vs. Canadian dollars, which is settled in one business day. The business day calculation excludes Saturdays, Sundays and legal holidays in either currency of the traded pair. During the Christmas and Easter season, some spot trades can take as long as six days to settle. Funds are exchanged on the settlement date, not the transaction date.

The U.S. dollar is the most actively traded currency. The euro is the most actively traded counter currency, followed by the Japanese yen, British pound and Swiss franc.

Market moves are driven by a combination of speculation, especially in the short term; economic strength and growth; and interest rate differentials.

Forward Transactions

Any forex transaction that settles for a date later than spot is considered a "forward." The price is calculated by adjusting the spot rate to account for the difference in interest rates between the two currencies. The amount of the adjustment is called "forward points." The forward points reflect only the interest rate differential between two markets. They are not a forecast of how the spot marketwill trade at a date in the future.

A forward is a tailor-made contract: it can be for any amount of money and can settle on any date that's not a weekend or holiday. Transactions with maturities longer than a year are relatively unusual, but are possible. As in a spot transaction, funds are exchanged on the settlement date.

Futures

A "future" is similar to a forward in that it's for a date longer than spot, and the price has the same basis. Unlike a forward, it's traded on an exchange, and can only be executed for specified amounts and dates. With a futures contract, the buyer pays a portion of the value of the contract up front. That value is marked-to-market daily, and the buyer either pays or receives money based on the change in value. Futures are most commonly used by speculators, and the contracts are usually closed out before maturity.

Differences Between Forex and Other Markets 

There are some major differences between the forex and other markets: 

  • Fewer rules: This means investors aren't held to as strict standards or regulations as those in the stock, futures or options markets. There are no clearing houses and no central bodies that oversee the forex market.
  • Fees and commissions: Since trades don't take place on a traditional exchange, you won't find the same fees or commissions that you would on another market.
  • Full access: There's no cut-off as to when you can and cannot trade. Because the market is open 24 hours a day, you can trade at any time of day.
  • Ease: Because it's such a liquid market, you can get in and out whenever you want and you can buy as much currency as you can afford. 
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Whale Watching: How to Spot Crypto Whales

A whale is a someone who has a lot of money to trade and can cause massive waves in the price of a cryptocurrency. Whales attempt to sway prices towards their preferred direction and usually succeed in the short-term.

Spotting a whale early could allow smaller traders to go along for the ride and profit alongside the whale as well as avoid being crushed by the whale and being left with losses.

How to Detect When A Whale Is BUYING

Looking to go long (buy) an altcoin? Why not wait for a whale to appear first?

CLUE #1: Look for abnormal increases in the bid size throughout the order book.

Let’s say this is a normal order book for a cryptocurrency. Normally, the average bid size is 1000 and the average ask size is 1000.

If there is a whale in the house, the order book might look like this:

Notice the difference in magnitude of the bid sizes.

CLUE #2: Look for an increase in volatility and price during a quiet period.

If a coin has been trading within a narrow range in a recent period, and all of a sudden….there is an unusual increase in volatility AND price spikes upwards, there could be a whale or whales in the house.

CLUE #3: Look for an acceleration of buying volume versus selling volume.

In a normal market, you’d usually see volume split evenly between the bid and the ask orders. This means 50% of the volume are buyers and 50% of the volume are sellers.

If price is an uptrend, buyers may be 60% of the volume, while sellers are 40%. And vice versa, if price is in a downtrend.

But if a whale is in the house, you’ll see an acceleration of volume on the buying side.

For example, if 90% of the volume is on bids within a short window of time, there’s probably a whale there.

How to Detect When A Whale Is SELLING

Assuming you’re not hodling, you don’t want to be long when there is a bearish whale, also known as a BearWhale, lurking.

CLUE #1: Look for sudden cancellations of big buy orders.

If you see large bid sizes starting to quickly disappear in the order book, there might a whale in the house who is about to take a massive dump (sell in large quantities).

Here’s what an order book might look like before the whale makes its move:

And here’s how it looks right before the whale is about to sell:

CLUE #2: Look for very strong momentum in price within a short amount of time.

When a coin has skyrocketed in price in a short amount of time, it’s considered to have very strong momentum. But it’s very likely that this momentum will quickly disappear just as fast as it appeared.

Why? Because the price was probably not driven by any new material information or real news, but due to a whale in the house driving up the price.

Once price has reached a certain level, the whale will stop eating (buying large quantities) and will want to take a massive dump (sell in large quantities).

CLUE #3: Look for very strong acceleration in volume.

If there is a sudden surge in volume and the amount of trading volume is abnormally high relative to recent volume (e.g. 3x larger than usual), there might be a whale in the house.