What is Leverage? – Beginners’ Guide

May 19, 2016

What is Leverage? – Beginners’ Guide

An investor in the foreign exchange market will deposit cash with his financial intermediary in order to hold currency positions.

The face amount he can trade usually exceeds the amount of cash on deposit; we say that he trades on leverage.

The face and counter amounts of a trade are not credited or debited to the investor’s deposit once a trade is done; the exposure simply remains open until a closing trade is effectuated.

While a trade is open, the cash deposit serves as a guarantee to cover potential losses.

When the trade is closed, the profit or loss will be converted into the investors original deposit currency, the cash on deposit is therefore never changed into another currency.

Thanks to the high liquidity and due to the fact that under normal circumstances price movements in foreign exchange tend to oscillate in a fairly moderate range most of the time, important levels of leverage can be used.

Face amounts of up to 200 times the cash on deposit can theoretically be traded. The degree of leverage one should use is determined by many factors.

Generally we like to urge the investor to use extreme caution and progress in slow steps. The following paragraphs will show that very high annual returns can be achieved on any investment amount without undertaking high degrees of risk.

To properly understand the concept of trading, one must know that foreign exchange speculation does not consist of a single investment that is held in an investment portfolio for an extended time period as is done with certain stocks, real estate or bonds.

Instead, successful currency speculation is done by accumulating profits through a rather large number of trades that are opened and closed in relatively short succession.

The leverage effect:

The effects of high leverage are illustrated in the following example.

Let’s first compare % and pips movements using EURUSD.

This currency pair tends to move in a fairly stable way with an average trading bandwidth of about 0.5%; a very volatile day may see it move by up to 3%:

Example:

EURUSD at 1.3000

percentage movement 0.10% 0.50% 1% 3%
pips movement 13 65 130 390
Rate down 1.2987 1.2935 1.287 1.261
Rate up 1.3013 1.3065 1.313 1.339

Cash deposit: USD 100,000

pips movement 13 65 130 390

face amount POTENTIAL PROFIT OR LOSS
leverage 1 1 lot 130 650 1,300 3,900
leverage 10 10 lots 1,300 6,500 13,000 39,000
leverage 100 100 lots 13,000 65,000 130,000 390,000

The example shows that the potential for profit or loss dramatically increases with higher leverage: The investor using no leverage (leverage 1) is exposing himself to a maximum loss of USD 3,900 in the event of a 3% movement in the wrong direction.

He can gain a maximum of USD 3,900 if the movement goes his way. The investor choosing a leverage of 10 (nominal investment * 10), is able to withstand a 3% market movement, but the price is high: The maximum loss of USD 39,000 represents 39% of his investment.

Of course, if the movement goes his way, he will gain this amount.

The investor going for 100 times leverage is risking more than he can afford with only a 1% market movement.

The moment that the unrealized losses equal the initial $100,000 deposit, the positions will be liquidated.

With the money gone, the investor will not be able to continue trading any further.

Of course if he is lucky, he could double his investment with a single trade in a single day.

NOTE: We have chosen EURUSD in order to have the profit or loss occur in USD.

However, since face amounts traded are in EUR while the account is denominated in USD, the actual leverage is 1.3000 times larger than the chosen 1/10/100 leverages cited in the above example.

Summing up:

The higher the leverage, the higher the potential risk or return.

Choosing too high a leverage may put a very substantial amount of your investment at risk.

On the other hand choosing too small a leverage may prohibit you from taking full advantage of the possibilities of the foreign exchange market, in which case the investor’s yearly performance may be too conservative.

How to choose the right leverage?

In order to answer this question correctly, one needs to look at the expected market movement of the currency pair to trade in and estimate the approximate time it may take for this movement to materialize.

The investor must define risk parameters, by setting a limit to the amount of money that he/she can afford to lose in case of an adverse market movement.

In short, the investor should carefully analyse each particular trade in advance in order to make a wise investment decision.

Example:

XAUUSD trades at 640; a movement to 660 is expected over the next 5-10 days:

  • movement from 640 to 660 is of $20 or 3.13%
  • time horizon: the movement could occur in as little as 1 day but should take no longer than 2 weeks
  • RISK: XAUUSD may drop, according to sources the 628 level is considered a strong support

Trade can be analysed in the following way:

Time horizon: XAUUSD is likely to experience several $20 movements in a single one month period; hence there is opportunity to make a similar trade 4 or 5 times per month!

Risk versus Reward: Target is a $20 beneficial movement.

With a strong support at 628, or $12 underneath the current price, the investor will consider his trade to be wrong only if that point is breeched.

Adding a little bit of leeway he intends to close the trade with a $14 loss at the 626 level: Potential gain of $20 versus potential loss of $14 is an acceptable risk/rewards ratio.

Leverage: One way of choosing leverage is to determine the total yearly return one may achieve using the assumption that 4 such trades can be done every month with a success ratio of 50%.

Having 2 losing and 2 winning trades per month, one expects to net $12 of potential gains each month (20+20-14-14), or $144 in a full year for every single unit of XAU traded.

1 unit XAU is worth $640, 144/640= 22.5% annual return with a leverage of 1, with a 10 times leverage a yearly return of 225% could be achieved.

As you can see in this example, choosing leverage between 2 and 5 is highly sufficient to make a very good annual return

Key elements to retain from this example:

  • At the time a new trade is opened, its closing strategy is known
  • Potential Benefit must exceed potential loss for good risk/reward
  • Timing Aspects must be respected
  • Low leverage permits steady income generation over time

A different approach that may help an investor choose a suitable leverage consists of looking at how long of a losing streak one may need to support.

In other words: what % of the investment one is willing to lose if there is a sequence of 10 or even more bad trades in a row:

Example:

USDJPY trades a daily average of 40 points. An investor is looking to capture 35 pips movements in his favour, if his position is wrong, he is willing to risk a maximum of 28 pips.

Assuming 20 trades are done per month, the investor experiencing a bad streak of 20 losing trades in a row will be losing 560 pips in total.

The aggregate loss of these 560 pips measured in USDJPY trading at 117 represents a 4.8% movement.

This means that a client trading with a 10 times leverage risks to lose 48% of his investment over the course of this 1 month period while an investor going with a 2 times leverage will risk less than 10%.

Diversification:

Similar to an investment in other assets, diversification is a good tool to reduce risks when trading in the foreign exchange market.

The principle of diversification is to hold exposures in multiple currency pairs using different time horizons. This permits to split up potential profit and losses into smaller, more manageable units.

Of course by increasing the number of open trades held simultaneously, exposure will increase and higher levels of leverage will be used.

A careful investor holding 3 to 6 open positions at the same time will therefore choose to leverage each individual trade by no more than a factor of 3.

Example:

Cash Deposit SAR 5mio Exposure SAR Leverage
OPEN TRADES Long 25 lots EURUSD at 1.3280 12.45mio 2.5
Short 5 lots GBPCHF at 2.3700 3.65mio 0.7
Short 20 lots XAGJPY at 1550 1.00mio 0.2
Short 20 lots USDCHF at 1.2150 7.50mio 1.5
Long 5 lots USDTRY at 1.3940 1.88mio 0.4
TOTAL 26.48mio
leverage factor 5.3

Increase and decrease position sizes:

An investor actively following his open position may use leverage in a slightly more aggressive way by increasing and decreasing the face amount of his open positions as prices evolve.

In order to help us understand this concept, we will take a look at the following price line, showing us price movements of GBPCHF between July ‘05 and March ’06: We can clearly see that this currency pair has oscillated in a range between 2.24 and 2.30 for 9 months, giving an active investor plenty of opportunities to sell when prices rise towards 2.30 and buy back as prices drop to 2.24. Assuming the expected price range has been set, the investor may trade the following way:

Example:

Cash Deposit: CHF 250,000
Date Trade Total position Leverage Pips profit
12. Jul 05 BUY 5 lots at 2.2600; open trade 1 LONG 5 4.5
19. Jul 05 BUY 5 lots at 2.2520: open trade 2 LONG 10 9
19. Jul 05 BUY 5 lots at 2.2440; open trade 3 LONG 10 13.5
28. Jul 05 SELL 5 lots at 2.2630; close trade 1 LONG 10 9 30
03. Aug 05 BUY 5 lots at 2.2450; open trade 4 LONG 15 13.5
15. Aug 05 SELL 5 lots at 2.2700; close trade 2 LONG 10 9 180
19. Aug 05 SELL 5 lots at 2.2820; close trade 3 LONG 5 4.5 380
30. Aug 05 BUY 5 lots at 2.2640; open trade 5 LONG 10 9
05. Sep 05 SELL 5 lots at 2.2720; close trade 4 LONG 5 4.5 270
08. Sep 05 SELL 5 lots at 2.2800; close trade 5 no exposure 0 160
12. Sep 05 SELL 5 lots at 2.2860; open trade 6 SHORT 5 4.5
16. Sep 05 SELL 5 lots at 2.2920; open trade 7 SHORT 10 9
20. Sep 05 SELL 5 lots at 2.3000; open trade 8 SHORT 15 13.5
05. Okt 05 BUY 5 lots at 2.2680; close trade 6 SHORT 10 9 180
05. Okt 05 BUY 5 lots at 2.2620; close trade 7 SHORT 5 4.5 300
06. Okt 05 BUY 5 lots at 2.2580; close trade 8 no exposure 0 420
1920
Profit: 500,000 (GBP per trade) * 1920 (total pips gain) = CHF 96,000
38% return in 3months

Note: Each time the net position is reduced, an existing trade is closed. This generates a string of profits, as the buy price is generally lower than the selling price.

Trading can be extremely profitable, the longer the range remains in place.

If many trades can be done, a lot of profits will be accumulated. Breaking out of the expected range will however end the strategy and the investor will have to close his last trades at a loss.

In the present example the investor should exit once 2.2250 is breeched to the downside or 2.3150 on top, allowing for some leeway around the chosen range boundaries of 2.24 and 2.30 respectively.

In the above example closing a maximum of 3 open positions would come at a total cost of 750 – 900 pips.

Short-term versus Long-term:

The previous example of GBPCHF was clearly a long-term trade, spanning over several months, during which a total of only 8 trade pairs were executed.

This requires a lot of patience on the side of the investor and certain skills to detect an extended period of range trading early enough.

Currencies however tend to oscillate all the time, in tight ranges if you look at a short time period, and in wider ranges if the time period is longer.

Compare the following chart with the example of GBPCHF above: Example: EURUSD oscillating in a 30 pip range over a 24-hour period A very active trader may choose to go short EURUSD above 1.3305 and go long underneath of the 1.3285 level. A large number of trades will be traded in a very short time-span. An investor is free to choose the time horizon he wants to expose himself to.

A key element in successful foreign exchange trading is to ‘stick to the plan’ and exercise a certain trading discipline.

This means that if a trade was entered with a short-term view, it must be closed before a large movement occurs even if it comes at a loss.

Of course short-term and long-term strategies may be mixed or dealt in parallel, once again with the idea of achieving better risk diversification.

Summing up leverage:

Trading in face amounts of between 0.5 to 3 times your initial cash deposits is reasonable – Before adding new trades, know your exit strategy in order to estimate potential profits and losses before they occur – Hold multiple currency pairs exposure to diversify risks while keeping an eye on overall leverage – Trading a short time horizon forces you to be more active – Trading long-term requires patience – Total leverage of 5 to 20 times allows for very good annual return while keeping risks in check

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