Greetings everyone!
I’m new to forex, and I don’t yet understand how leveraging works. When a broker says that they offer a leveraging of 100, they say that for every $1 invested, I’ll be trading with $100, but where does this money come from? From the broker itself? Or does he borrow it from someone else?
The broker has the money. They use the money they make off the spread I’m assuming (that’s how they make their money anyhow). someone correct me if I am wrong. The higher the leverage the more broker money goes into the trade and less of your money. But higher leverage also means larger profit or visa versa, larger loss.
Haha, nobody has the money. You don’t need the capital to purchase/sell the entire value of the contract, you just need to be able to cover the Profit/Loss. You are either Long or Short on the contract. Your broker owes you the money if the contract is profitable at market value, and you owe your broker if the contract is losing at market value.
The larger your contract value (lot size, position size, all the same thing), the larger your PIP VALUE. This is how price movement is translated into $ P/L
Nice! That makes perfect sense. Seeing as most of our money is all electronic anyhow. So what does it matter if it’s there or not as long as the ends are met
One reason that leverage is so confusing to new traders is that it is frequently explained in misleading ways — often by brokers, themselves.
Let’s deal with the really hard issues first. If you can get these right, the rest is easy.
B[/B] When you trade a large position (larger than your account balance), [B]you are not trading with someone else’s money.[/B] Nobody lends you money at any time during your trading. Your broker certainly is not going to allow you to mess around with any of [I]his[/I] money.
B[/B] When you take a position in the forex market, [B]you do not buy or sell anything,[/B] despite the fact that everyone involved in forex trading refers to going long as “buying”, and going short as "selling. You will even hear people tell you that when you “buy” a particular currency pair, you are “buying” the base currency, and “selling” the cross-currency. This is [I]false,[/I] and that kind of jargon is very misleading for new traders who are trying to grasp the mechanics of forex speculation.
Let’s look at how (1) and (2) above play out in actual forex trading.
A position in spot forex does not involve a purchase or sale. It actually resembles a bet. When you go long the USD/JPY, for example, you are “betting” that the USD will increase in value compared to the JPY. If that occurs, then you earn a profit equal to the unit-value of the increase TIMES the number of USD involved in your “bet”.
If the opposite occurs, and the value of the USD declines compared to the JPY, then you take a loss equal to the unit-value of the decline TIMES the number of USD involved in your “bet”.
Obviously, your profit potential depends on (1) the size of a price move in your direction, and (2) the number of USD involved in your “bet”, that is, the number of USD in your position. A bigger position means larger profit potential (as well as larger loss potential). Speculating in spot forex is worthwhile precisely because we are able to take large positions relative to the dollar-amounts in our accounts.
The ratio of position size to account size is called “leverage”. If your broker allows you 100:1 leverage, he is allowing you to open a position [I]up to[/I] 100 times the size of your account. This is called “maximum allowable leverage”, “broker leverage”, or “offered leverage”.
If you open a position which is only 5 times the size of your account, then you will be using only 5:1 “actual leverage”, regardless of the “maximum allowable leverage” offered to you.
Maximum allowable leverage is how brokers specify “required margin”. Brokers like to talk in terms of leverage, rather than required margin, because it makes for better advertising to emphasize the big positions you can trade, rather than the funds you must deposit.
Required margin is the inverse of maximum allowable leverage. That is, Required Margin = 1 ÷ Maximum Allowable Leverage.
Leverage of 100:1 corresponds to 1% margin. Leverage of 50:1 corresponds to 2% margin. Leverage of 200:1 corresponds to ½% margin. And so forth.
If your broker allows you to use up to 100:1 leverage, he is saying that you must post margin equal to 1% of your position size (regardless of how much actual leverage you choose to use). As soon as you open a position, your broker will set aside, as margin, a portion of your account balance, equal to 1% of the notional value of your position. That margin amount will not be available to you for any other use, for the duration of your trade. As soon as your trade is closed, your margin amount will be released back to you. The real purpose of margin is to provide a cushion to protect your broker from losses caused by you. You can think of margin as your “skin in the game”.
Let’s summarize all this:
When you take a position in spot forex, you do not buy or sell anything, and you do not borrow money in order to use leverage. Your position, whether long or short, is similar to a bet on the direction of price. Your bet can involve a base-currency amount (your position size) that is many times the size of your actual account. The ratio of your position size to your account size is called “actual leverage”.
A small portion of your position must be funded by you, and this small portion, called “margin”, is directly related to the “maximum allowable leverage” offered to you by your broker. The rest of your position is not funded by you, or by anyone else. You are not borrowing this unfunded portion. Lending and borrowing do not occur in retail spot forex trading.
Clint,
Where do you get the motivation to post these responses?
I just hope he never loses the motivation.
These posts are like gold.
They should have a “Clint” section in the school.
I make sure to read all of his posts, because even if I know the answers, he is so thorough that I’m bound to learn
something new, or gain a different perspective.
(But I am a bit curious, is it coffee? What motivates him?)
Sometimes it’s easy to forget that there are real people behind these screen names… and whoever is behind the Clint screen name has a lot of patience for newbies and what I assume is an obsession with accuracy, haha
Is obsession a requirement for trading success? something I’ve been wondering lately. I know I have OCD, I heard ICT say he’s got the OCD, and I just can’t imagine Clint not being on that bandwagon too
Which let me say is encouraging, because I do believe Clint and ICT both live off their trading profits. It’s nice to have something in common with the Greats 
Sorry to psychoanalyze you Clint, I just wish I knew you better lol
You guys are right, Clint’s explanatory posts are always worth reading, no matter if you know the answer or not.
I think Clint (and the same goes for Michael, aka ICT) is just [I]totally obsessed[/I] with forex trading, has done it for quite a long time and consequently knows a lot about it.
In addition he is one of those people who genuinely enjoy teaching others … and who have a knack for it, being able to break down complex issues into terms easily understood by somebody not familiar with the topic.
Those are the members that every forum needs to be interesting and informative, i.e. ultimately successful.
Looking at all the time and effort that ICT invested into his many videos, and that Clint invested into his many threads and posts (e.g. this one, dealing with time shifts in trading sessions due to DST changes), we are lucky to be part of this community … there is always something to be learned.
Thanks a lot, you guys. 
Cheers,
O.
[B]Aaron[/B] (akeakamai), [B]piptronix,[/B] and [B]O[/B] (Oliver1968),
You guys are embarrassing me. But, thanks for the kind words.
Since you guys are talking leverage, I’ve experimented and understand the concept especially after reading Clint’s great write-up. My question though, is what leverage do you guys recommend? Really, I think it’s down to a good risk management strategy, you want to have the potential for big profits but you also want to safeguard against big loss. That’s the dilemma.
Hello, Goldie
Regarding your leverage questions, in my trading I never think about how much leverage I’m actually using, because I control my risk directly in every trade, and my risk calculations typically are based on stop-losses in the range of 20 pips, or more.
I have said many times that if you manage risk properly, you will never have to worry about leverage, and you will never face a margin-call. With the stop-losses that I typically use, that statement is true, [B]but…[/B]
…there is one important exception to that general statement: If you B[/B] limit your trade risk in the way that I advocate, B[/B] trade with very tight stop-losses (say, on the order of 10 pips, or less), and B[/B] trade through a U.S. broker (where your maximum allowable leverage is limited to a ridiculous 50:1), [B]you can be seriously over-leveraged,[/B] and you can end up facing a margin-call, even before your SL is hit.
Let’s run some numbers to illustrate how risk management determines actual leverage used:
Let’s say that two traders take exactly the same LONG trade, based on what their charts are telling them. Let’s say that strong support resides 25 pips below current price, and the next significant resistance level is some distance above current price. Our two traders enter market orders at exactly the same time, and get filled at exactly the same price. They each set a stop-loss 33 pips below entry price, and they both decide to manage profit manually (and exit a profitable trade manually).
Trader #1 has a $500 account balance. Trader #2 has a $500,000 account balance.
Which trader is taking more risk? Which trader is more highly leveraged?
You don’t have enough information to answer those questions, because you don’t know either trader’s [B]position size.[/B]
In each case, the risk in pips is the same (33 pips). And the menu of pip-values is the same for both traders (because they are trading the same pair). In this trade, let’s say that pip-values are $10 per pip for standard lots, $1 per pip for mini-lots, and $0.10 per pip for micro-lots.
Suppose each trader chooses to risk 2% of account balance on this trade. Now you have the information needed to calculate position size, risk in dollars, and actual leverage used, for each trader in our example. Here’s how:
Two percent of account balance for trader #1 is $10. Therefore, the trade entered by trader #1 was for 3 micro-lots. If his 3-micro-lot position runs to his SL, his dollar-loss will be 33 pips x $0.10 per pip x 3 micro-lots = $9.90. His risk percentage is $9.90 ÷ $500 = 1.98% — essentially 2%.
Two percent of account balance for trader #2 is $10,000. Therefore, the trade entered by trader #2 was for 3,000,000 units of base currency = 30 standard lots. If his 30-standard-lot position runs to his SL, his dollar-loss will be 33 pips x $10 per pip x 30 standard lots = $9,900. His risk percentage is $9,900 ÷ $500,000 = 1.98% — exactly the same risk percentage as trader #1.
Even without calculating the actual leverage used by these two traders, I can tell you that B[/B] it was identical for both traders, and B[/B] it was very conservative leverage. These two traders have dramatically different account balances, and dramatically different position sizes, but they each manage trade risk in the same, consistent way.
Neither trader even needs to bother calculating how much actual leverage was used in the trade described above. Each one of them knows that conservative risk management results in the conservative use of leverage — [B]except[/B] in situations involving very tight stop-losses (such as scalping a 1-minute or 5-minute chart), under a regime where 50:1 is the maximum leverage allowed by law.
As a homework assignment, calculate the actual leverage used by each trader in the example above. That will tell you the actual leverage that I typically use, because my trades are typically similar to the trade in the example above.
Then, as a further exercise, [B]change the risk in pips to 99 pips,[/B] keeping the risk percentage at 2% in each case, and see whether that changes the actual leverage used.
Finally,[B] change the risk in pips to 11 pips,[/B] again keeping the risk percentage at 2% in each case, and run the numbers again to see the effect on leverage.
If you’re so inclined, you can report back here with your findings.
As for the dilemma (as you call it) of trying to capture big profits, while taking small risks, those two things are not necessarily mutually exclusive. With intelligent trade selection, you can have strictly limited risk [B]and[/B] big profit potential. But, that’s a topic for another time.
Hi Clint.
Wow – thanks for the info and explanation. I’ll do my homework and see what I find.
I see your point though about managing risk and correct usage of stop-losses. I use an EU broker and the maximum leverage is 1:500 even though I have no intention of leveraging that high any time soon!
Thanks again.
thank you for the explanation. I was completley confused about leverage and was looking for an answer everywhere and this explanation is simple to understand! Thank you!
Nice explanation, Client, well done!
Great explanation about Leverage Clint. I’m newbie too and I believe I understand it better with your replies. If it’s not too much to ask, can you explain a bit more on the mechanics of how Forex trading works for retail traders that use margin? (related to what’s underlined in the quote).
Brolin8,
A lot of careless jargon is bandied about in the world of forex trading, and some of it comes from forex brokers, who should know better. The quote (from post #1) that you referred to contains some of that jargon — specifically, the statement that “for every $1 invested, I’ll be trading with $100”. That statement is so full of errors, we’d better spend some time trying to clean it up.
When you deposit physical (cash) money into a forex account, your deposit is not an “investment”. And when you take a position (open a trade) in your forex account, no part of your account or your transaction is, in any way, an investment. There is no investing in retail forex.
Suppose you change the word “invested” to read “deposited” in the statement quoted above. Then it would read “for every $1 deposited, I’ll be trading with $100”. The statement is still wrong. You trade with the actual money in your account, period. The money in your account must be sufficient to do three things: it must cover the margin which your broker requires on each trade, it must cover the spread which he charges on each trade, and it must cover any loss which occurs while your trade is open or when it is closed.
So, what would be a correct statement? — “For every $1 deposited, ________________________________”.
How should we fill in the blank? How about this:
[B]For every $1 deposited, I will be able to trade a notional amount (position size) larger than $1, up to a maximum amount approaching $100.[/B]
If that statement is correct, you can see why no broker would use it: it’s too complicated. It’s easier for a broker to create a sort of sales-pitch about the magic of leverage, which makes it sound like “you deposit $1, and we’ll give you $100 to trade with”.
Let’s dissect the statement in bold type, above.
I think we have made it clear what “$1 deposited” means. But, just to drive the point home, it’s a real dollar — cash money, which you could have spent at Walmart, if you hadn’t deposited it into a forex account. As you’ll see in a moment, the rest of that “$100” doesn’t exist.
“Notional amount” is the kind of term you see used in brokers’ customer agreements, and in stuff published by the NFA and the CFTC. It simply means the dollar-value, or the sterling-value, or the euro-value (as the case may be) of a trade. And “position size” means the same thing. If you trade one standard lot of USD/JPY, the notional amount of your trade is $100,000. If you trade one mini-lot of GBP/USD, the notional amount of your trade is £10000. And, if you trade one micro-lot of EUR/JPY, the notional amount of your trade is €1000. Notice that the notional amount (position size) is determined by the base currency in the pair traded.
Okay, so why does the bolded statement above say that you will be able to trade a notional amount…“up to a maximum amount approaching $100”? The anwer has to do with (1) the fixed relationship between leverage and margin, and (2) the fact that, if you committed your entire account balance to margin, there would be nothing left to cover the other two things that your account must cover — the spread, and losses.
Here’s a quick example: Your forex account offers you maximum allowable leverage of 100:1. You have a balance of exactly $1,000. You open a one-standard-lot position in USD/CAD. The notional amount of this trade is $100,000.
That’s okay, because you have 100:1 leverage, right? Wrong.
As soon as you open this trade, your entire account gets “set aside” in margin; then, your account is charged the applicable spread (say, 5 pips, which equals about $50 in this trade). But, your account doesn’t have the additional $50 needed to cover the spread, so your trade is immediately closed in the world’s fastest margin-call.
So, long story short, you can trade a very large position in your little $1,000 account, if you’re fool-hardy, but you can’t go all the way to $100,000 in position size.
Now that we’ve torn the statement you quoted to shreds, let’s address the question which followed that statement, specifically, if you deposit only $1 to a forex account, where does the rest of the $100 come from? I hope you see now that there is no $100. You didn’t deposit $100, and no broker in the world in going to lend you $100 (or any other sum of money). Your $1 allows you to place a “bet” (not to exceed a certain size) on the currency pair of your choice. The “certain size” that you can’t exceed is determined by the margin amount required by your broker, and this margin amount is mathematically related to the maximum allowable leverage which your broker offers. 100:1 leverage means 1% margin required; 200:1 leverage means ½% margin; 50:1 leverage means 2% margin; and so forth.
I hope this clears things up for you. If you still have questions, re-read post #5 in this thread. Then, if there’s still a problem, come back and ask more questions.
Clint,
Thank you for your response. I believe it’s clear now. The only money that it’s at stake is what you have deposited in your account (depending on size position, it can vary on each trade). The other (leverage money) doesn’t really exist for the retail trader. It’s not borrowed money. It’s just for speculation purposes.
Now, all those price fluctuations that we see on the broker’s platform come from REAL money traded between the big guys right? (banks, investors, goverments, etc) We’re just allowed to speculate on what they will do (the real buyers and sellers). Am I right?
I’m not sure what you mean by “money that is at stake”. I would say it this way: Your account balance consists of all your deposited funds, minus all your withdrawals, plus all your profits, minus all your losses, plus any interest earned in daily roll-overs, minus any interest charged in daily roll-overs. This total — your account balance — is real money. It is all yours. And it is all you have to work with (to cover margins, spreads, and losses or drawdowns); it is, in other words, your working capital.
Only a tiny fraction of this total (your account balance) should ever be at risk in any trade, or in all open trades combined at any one time. The amount at risk at any one time (which could be called “money at stake”) will vary from zero (when you have no open trades) to possibly 2% (+/-) of your account balance (when a trade is open).
[B]There is no other money[/B] — “for speculation purposes” or for any other purpose.
You seem to be describing the retail forex market (our market) as if it’s disconnected from the “real” market where prices are determined. It is not disconnected. But, the connection goes through several hands.
In the simplest case, when you place a trade with your retail forex broker, he offsets that trade with one of the big banks which provide him with “liquidity”. If you open a LONG position, your broker automatically takes the other side of your trade, putting him in a SHORT position. If you open a SHORT position, your broker takes the other side, putting him in a LONG position. He offsets his position by [B]mirroring[/B] your trade with his liquidity provider. That is, if you are LONG one lot of EUR/USD (with your broker), your broker will offset his exposure to your trade by going LONG one lot of EUR/USD with his liquidity provider.
The net result is that your trade passes [B]through[/B] your broker, and enters the interbank market, where it [B]does[/B] interact with all the other currency transactions coming into the market, from all over the world. All of these transactions (including yours), acting together, drive prices.
Can [B]your[/B] individual trades have a measurable effect on price? No. The currency market is way too big, and your trades are way too tiny to matter to the market.
Can all the retail spot forex traders in the world move prices to any significant degree? Not likely. Retail spot forex (our market) is less than 3½% of the overall worldwide foreign exchange market — and that $4 trillion-per-day worldwide foreign exchange market is where prices are established.
For more on forex market metrics see this thread.
Clint - I saw somewhere that 18% of global spot fx was retail now. Seems quite high but not impossible. Anyway, your main point that single trades in retail aren’t the ‘London Whale’ is spot on. We would need to place a 100m trade to influence the market!