What is Effective Leverage in Forex?
It is important for traders to know about how trading with leverage and how forex margin works since these terms will likely come into play one time or another if you plan on trading forex for a living.
Leverage in forex trading involves a broker allowing a trader the ability to open trade positions with capital that the trader does not have, which enables the trader the opportunity to make a large return on an open trade position much higher than what they would be capable of without the use of leverage.
Leverage helps immensely, especially for a forex trader who wants to make big profits that they would not be able to otherwise.
However, leverage can also be very dangerous- while it can help traders make large returns, it can also mean big losses that they might now be able to afford.
So, what is effective leverage?
Effective leverage in forex is the amount of capital used in relation to the total value of an open trade position.
Effective leverage is essentially the position value as compared with the total account equity of the account, including unrealized profits and losses.
So, the effective leverage in forex represents the changing leverage amount for an open position as the price changes.
This is sometimes a tricky concept to grasp, especially if you are new to the terms and forex.
Keep reading if you want to see it broken down with the effective leverage formula and an example.
How to Calculate Effective Leverage (Formula)
The formula for calculating effective leverage is as follows:
This is the simplified version of the formula.
The more clarified formula for effective leverage is as follows:
You will probably need a calculator in order to calculate the effective leverage.
Examples of Effective Leverage in Forex
Effective leverage will certainly come into play if you decide to use leverage in forex trading which, if you trade for long, you probably will use.
Here are some quick examples to illustrate how effective leverage is calculated with real scenarios.
- Trader A’s account balance is £10,000 and he shorts 20 standard lots of EUR/USD:
- Effective leverage= (20 x £100,000)/£10,000 = 200:1
- Trader B ‘s account balance is also £10,000 and he shorts 20 mini lots of EUR/USD:
- Effective leverage= (20 x £10,000)/£10,000 = 20:1
Trader A’s effective leverage is 200:1 and Trader B’s is 20:1.
The leverage difference between the two traders has an increasing effect on each pip value, which also increases the volatility impact.
Trader A has the opportunity to score a profit about 10 times larget than Trader B, but as is common with leverage, a negative move of currency price can be much more detrimental to Trader A.
Why Does Effective Leverage Change?
If the price of your currency changes in your favor so that your current position is in profit, then your effective leverage level will now be lower since your portfolio now has more value. This is thanks to unrealized profit, which means lower effective leverage.
This is also true vice versa.
The currency prices move against your open position, effective leverage will then rise since there is less collateral now available thanks to unrealized loss.
Learn to Trade Forex
Learning terms such as effective leverage definitely helps you become a better trade. After all, these are aspects of forex trading that you will likely have to deal with one time or another, especially if you find yourself trading long term.
That said, simply knowing definitions will hardly help much when it comes to actually making money.
Memorizing definitions help with general knowledge, but in order to make consistent, profitable trades, it’s important to learn the strategy and how the markets work.
If you are a beginner to intermediate forex trader and you want to take your earnings to the next level and start making some coin, then we suggest you take the time to truly educate yourself and see how professional forex traders make six-figures each and every year.
If you’re interested in taking your forex trading skills to the next level, head on over to our post about a forex course that will teach you everything you need to know and more.
Also, if you want some more help, make sure to grab our Free Forex Trading PDF – look to the sidebar to the left of this post to see how you can get your copy sent straight to your email, today.