Understanding Maximum vs. Used Leverage

Understanding Maximum vs. Used Leverage | Understanding Notional Value

The retail forex market has offered high leverage terms in recent years and though that has enticed some traders to the industry, there are some misconceptions in regards to leverage. For starters, even though forex brokers may offer up to 400:1 leverage, what they are actually referring to is the maximum leverage that they allow to open a position. Maximum leverage in this context refers to the amount of margin required to open a position. For instance, with 100:1 leverage a trader is required to set aside $1,000 in margin in order to open a standard lot position which is equivalent to $100,000 or 100 times the margin. Therefore, if a client has a $5,000 account balance and opens a standard lot they would set aside $1,000 as margin and have $4,000 in usable margin that if lost will initiate a margin call. Remember to keep in mind that leverage may increase potential gains or losses on any given position.

While maximum leverage is handy in comparing brokers' trading terms, a better representation of the amount a client's account is leveraged is called used leverage. Used leverage is calculated by comparing the size of your position(s) to the total amount of money in your trading account, or your account equity. In reality, the used leverage for forex traders is usually much smaller than the maximum leverage with CMS Forex clients' average used leverage at approximately 12:1.

Consider an example of used leverage and how it is calculated to showcase that point. A client starts with a $10,000 trading account and buys 1 standard lot (or $100,000) of USD/JPY. To calculate the used leverage you would divide the size of the position by the account balance. In this example, the used leverage is 10:1 ($100,000/$10,000). If one had opened two standard lots with the same $10,000 trading account the used leverage would be 20:1 ($200,000/$10,000). Even though the account may have been opened with the prospect of using 400:1, maximum leverage has more to do with your margin requirements than it does with how leveraged your account is.

In the upcoming second example we show a client trading with a higher used leverage, and how that creates the potential for the client to see sharp swings in their account equity from even small pip movements.

An account with a $2,000 trading balance opens a standard lot of USD/JPY. The used leverage on the account in this example is much higher at 50:1 ($100,000/$2,000). If the broker requires a 1% margin to open a position, one would need to set aside $1,000 in order to open the standard lot. Therefore with the margin set aside, there would be another $1,000 in the account that is “usable margin” or the amount that would be added to or subtracted from when the currency price changes. If that $1,000 in usable margin is depleted, the trader will receive a margin call. Considering each pip on a standard lot of USD/JPY is worth around $10 it would only take a move of 100 pips (100 x $10 = $1,000) to trigger a margin call. If that was to happen under non-volatile market conditions, the account would be left with only the original margin amount, $1,000, and the trading account would have lost 50% of its balance. By trading with such a high used leverage, or overleveraging, the trader is exposed to more volatile swings in their account equity and may sustain greater losses. Most traders, instinctively trade on a smaller used leverage in order to give themselves more leeway or breathing room from initiating a margin call should the position(s) go against them.

In the above example, the trader with a $2,000 account should consider a lower used leverage by trading mini-lots ($10,000 sized positions) to avoid overleveraging his or her account. This way, even when opening two mini-lots ($20,000) the used leverage is 10:1 ($20,000/$2,000). Each pip move for the 2 mini-lot position is worth around $2 and it would take a move of 1,800 pips to receive a margin call.

Understanding Notional Value

In the forex market all contract sizes are not created equal. The standard size of a position is called a Lot. The size of 1 Lot is 100,000 units of the top currency (or the base currency) in a currency pair. For instance, 1 Lot of USD/JPY is equal to 100,000 USD, while 1 Lot of EUR/USD is equal to 100,000 EUR. Therefore, even though both contracts are 1 Standard Lot, they have different notional values. When opening a position the different notional values will affect how much margin is required to take out that position.

Example #1:

1 Lot of USD/JPY = 100,000 USD;

At 1% margin = 100,000 USD x 0.01 = $1,000 USD required for margin

Example #2:

1 Lot of EUR/USD = 100,000 EUR;

Convert to USD (exchange rate = 1.3650) = 100,000 EUR x 1.3650 = 136,500 USD.

At 1% margin = 136,500 USD x 0.01 = $1,365 USD required for margin.

These examples show margin requirements of 1% (or 100:1 maximum leverage), while more exotic currency pairs require 4% margin (or 25:1 maximum leverage).

Example #3:

The US Dollar-Singapore Dollar pair for instance is an exotic currency pair and would require a higher margin. The notional value of the position is the same as the USD/JPY since the US Dollar is the base currency in both currency pairs:

1 Lot of USD/SGD = 100,000 USD;

At 4% margin = 100,000 USD x 0.04 = $4,000 USD for margin.

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Trading foreign exchange and futures on margin carries a high level of risk, and may not be suitable for all investors. The high degree of leverage can work against you as well as for you.