Since the beginning of the 21st century, the Forex market and market of Contracts for Difference (CFDs) have been experiencing a period of dynamic development. Investors tend to favour these markets primarily in search of high liquidity, low transaction costs and the possibility of speculation, irrespective of the prevailing market trends, anticipating both increases and decreases in instrument prices. An inseparable feature of the Forex market and CFDs is also the mechanism of financial leverage, which makes these markets even more interesting from the perspective of traders. Therefore, it is now worth asking the question – what is Forex leverage and how to use it properly.
What is Forex leverage?
To properly define the term of financial leverage – in other words, leverage or Forex leverage- it is worth starting with a brief description of financial instruments which offer this leverage – we refer to CFDs (Contracts for Difference). A Contract for Difference – as the name suggests – is an agreement between two parties, which obliges the parties to settle the difference between the opening and closing price of such a contract. If an investor has bought a CFD – it is said that he has taken a long position in a given instrument – and the price of this instrument goes up, the investor will make a profit, because the price of closing the contract will be higher than the price of opening it. In the second case, when the investor decides to sell a CFD contract – in which case the investor holds a short position – he/she will make a profit when the instrument price decreases and the closing price of the contract is lower than the opening price of the contract.
CFDs are derivative instruments, which means that their value depends on the underlying instrument to which a given contract has been issued. CFDs themselves do not transfer the rights to the underlying assets to the contract holder – only differences in the opening and closing price of the contract are settled. This means that CFDs are speculative instruments and investor’s goal is to analyze and try to predict in which direction price of the contract will change. An important advantage of CFDs is the wide range of their underlying assets – Forex, commodities, stock indices, stocks or cryptocurrencies. Thanks to this, from one trading platform investor, gains access to an extremely rich product offer and the possibility to trade instruments from all over the world.
Is there anything else we have not mentioned yet, that is very characteristic to CFDs? Yes, it is the financial leverage. Margin trading is an inherent feature of Forex trading and CFD trading. Margin trading is based on the principle that in order to open a position, an investor needs to hold only a part of the capital corresponding with his market position. This part of the capital, known as margin, can only represent a fraction of the investor’s market position and depends on the level of leverage investor operates with. In practice, thanks to the leverage effect, investors can speculate on market positions that exceed their equity by up to 30, 100 or 500 times.
Forex leverage formula – Calculation of Forex leverage
It is not difficult to calculate leverage. As leverage tells the investor how many times his market position exceeds the amount of his margin, the leverage formula can be described as follows:
Financial leverage = size of position / margin
According to the leverage calculation formula presented above, if an investor has an open market position worth 10,000 EUR and his margin is 100 EUR, the leverage will be 10,000 / 100 = 100. Interpretation of the leverage equal to 100 is that the investor’s market position is leveraged 100 times – the investor needs a margin of only 1% of his position. Similarly, the higher the leverage on the trader’s account, the lower the level of margin required to open any position. If the investor works with Forex leverage of 200, he will need only 50 EUR of his own equity on the account to open a market position worth 10,000 EUR. Since the degree of leverage is expressed as the ratio of the investor’s capital versus the size of the market position, it is common among Forex traders to say – Forex leverage 1:100 (leverage one to one hundred) or 1:200 (leverage one to two hundred).
By knowing the amount of leverage on the account, the trader can easily calculate two values – the maximum amount of the position which he can open on his Forex trading account and the amount of deposit that he has to hold to open and maintain such a position. The calculations we are talking about are done automatically by the trading platform and there is no need for the trader to do them himself every time. Nevertheless, it is always worth knowing how the leverage mechanism looks like and where the individual values that we see on the trading platform come from.
Forex leverage example and Forex leverage interpretation
Since 1 August 2018, European Securities and Markets Authority (ESMA) regulations have been in force in EU countries, imposing a maximum leverage level offered by brokers registered in the EU to 1:30. For investors who previously traded with a leverage of 1:100, this means that they will need 3 times more funds to open the same market position, and investors who had been investing with a leverage of 1:500 will be forced to increase their deposit requirement almost by 17 times. Are the leverage caps introduced beneficial for Forex and CFD investors? We described that on the following examples:
Forex leverage example – EURUSD 1 lot on 1:500 Forex leverage:
Opening a position of 1 lot (100,000 units of the base currency, in this case, 100,000 EUR) with a leverage of 1:500 requires from investor to hold margin of only 0.2% of the contract value, i.e. 200 EUR (0.2% x 100,000 EUR). While trading Forex on 1:500 leveraged account, the investor receives an extremely high leverage, allowing him to open large market positions with little of his own equity. Therefore, both – potential gains and losses resulting from a high leverage mechanism – will have a significant impact on the investor’s account.
Forex leverage example – EURUSD 1 lot on 1:100 Forex leverage:
A position of 1 lot on EURUSD with a leverage of 1:100 will require from investor to cover margin of 1% of the contract value, i.e. in the amount of 1000 EUR (1% x 100 000). Forex leverage in this example is still very high as the investor receives the possibility to speculate on the market with amounts exceeding his own capital 100 times. As in the previous example, potential profits and losses are thus highly multiplied.
Forex leverage example – EURUSD 1 lot on 1:30 Forex leverage:
The same position as in previous examples, i.e. 1.0 lot on EURUSD but with only 1:30 Forex leverage will require from investor to hold margin of 3.33%, i.e. 3333.33 EUR (3.33% x 100,000). Traders’ markets positions continue to be multiplied but the Forex leverage effect is already much lower than in the first and second example, where leverage was 1:100 and 1:500, respectively.
Interpretation of Forex leverage in the above examples is intuitive – the same market position of 1 lot on EURUSD will require from Forex trader margin of 200 EUR, 1000 EUR and 3333.33 EUR, respectively. In all three cases position size has been identical (1 lot), so was the value of one pip, equal to $10. The rhetorical question arises then – how should an investor benefit from a lower level of Forex leverage in Europe if it requires more funds on the account to open and hold the same market position? On the upside, regulations limiting leverage to 1:30 apply only to EU brokers but do not apply to brokers operating in other jurisdictions – Australia and Switzerland. Therefore, investors looking for a leverage higher than 1:30 should consider moving their trading accounts to IC Markets or IFM Trade (Australian brokers) or Dukascopy Bank (Swiss bank).
Forex leverage in Australia and Switzerland
ESMA regulations apply only to Forex brokers and CFD brokers operating in the European Union. This means that the restrictions on leverage to 1:30 for Forex, 1:20 for indices and 1:10 for commodities do not apply to Australia and Switzerland. Among Australian brokers, two of them are worth mentioning – IC Markets and IFM Trade. Both IC Markets and IFM Trade are regulated entities – licensed to provide brokerage activities – under the supervision of the Australian Securities and Investments Commission (ASIC). This means that the activities of IC Markets and IFM Trade are fully transparent and meet the highest market standards. IC Markets and IFM Trade offer excellent trading conditions on STP/ECN trading accounts. Major pairs spreads are as low as 0.0 pips with extremely competitive commissions. The product offer includes CFDs on Forex, major stock market indices, commodities and cryptocurrencies. IFM Trade offers market access via the MetaTrader platform, while IC Markets offers both MetaTrader and cTrader as well. Account registration procedure is intuitive and all documents can be sent electronically in scan copies.
Outside Australia, Forex leverage higher than 1:30 can be found with brokers under the supervision of the Swiss Financial Market Supervisory Authority (FINMA). Dukascopy Bank is such a broker, or rather a bank, as in Switzerland Forex market access services may be provided only by entities holding a banking license. Dukascopy Bank offers a maximum Forex leverage of 1:200. Thanks to the banking license, customers’ funds deposited with Dukascopy Bank are protected by the Swiss guarantee fund and are guaranteed up to the equivalent of 100,000 CHF. This amount is far greater compared to the financial services compensation schemes available in the European Union countries, which offer customers’ funds protection up to 20,000 EUR. Dukascopy Bank offers market access through the well-known and valued by Forex traders platform MetaTrader and JForex. Spreads at DukasCopy Bank are as low as 0.2 pips and the product offer includes, among others, CFDs on Forex, stock indices, commodities and metals. Account application process is fairly simple and may be completed fully electronically.