Leverage basically means the borrowing of a certain amount of the money that is needed for investment. In our case, the Forex. The money is is usually borrowed from your broker. In Forex trading the possibility of using high leverage in the sense that for an initial margin requirement, a trader can build up and control a huge amount of money.
In order to calculate your margin-based leverage, you will need to divide your total transaction value (US$) by the amount of margin (US$) you are required to put up.
Margin-Based Leverage = Total Value of Transaction / Margin Required
Look at this example. If you are needed to deposit 1% of the total transaction value as your margin and you intend to trade one standard lot of USDJPY which is equivalent to US$100,000. The margin that you required would be US$1,000. Thus, your margin-based leverage will be calculated as: -
Levererage = 100,000 / 1,000 = 100:1.
For a margin requirement of 0.5%, your margin-based leverage will be 200:1 using the same equation.
I have discussed about margin-based leverage. However, margin-based leverage will not necessarily affect one's risks. It does not matter whethere you are required to put up 1%, 2% or even 3% of the transaction value as margin. This will not influence your profits or losses. This is because you can always attribute more than the required margin for any position. What it means in this case is that you need to look at your real leverage, and not margin-based leverage.
How do you do that? Simply, to calculate the real leverage you are currently using, you can apply the following equation: -
Real Leverage = Total Value of Transactions (Open Positions)/ Total Trading Capital
As an example, if you deposit $5,000 into your trading account, and you have decided to open a standard lot (which is equivalent to $100,000), you will be trading with a 20 times leverage on your account (100,000/5,000). If you trade two standard lots, which is worth $200,000 in face value with $5,000 in your account, then your leverage on the account is 40 times (200,000/5,000).
The only time that margin-based leverage and real leverage will be equal is when you are trading to your maximum. And since you do not normally use your entire account as margin for each of your trades, your real leverage tends to vary from your margin-based leverage.
In the next post, I will discussed about Margin Call by your broker.
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