When it comes to leverage in foreign exchange trading, it can generally be divided into “over-the-counter leverage” and “exchange-traded leverage.”
“Off-exchange leverage” refers to a situation where the funds in an investor’s foreign exchange trading account do not come entirely from the investor’s own capital, but rather are obtained through leverage—such as borrowing from a third party—to increase the amount of capital available for trading. This method of leveraging is relatively common in various other types of trading as well.
“On-exchange leverage” refers to the situation in foreign exchange trading where, due to the margin system, investors are typically able to use this trading mechanism to execute trades worth several times—or even hundreds of times—the amount of funds they hold in their trading accounts. This gives rise to leverage in foreign exchange trading,This type of trading is also known as “leveraged forex trading” or “forex margin trading.”
The following specific examples will help you gain a clearer understanding of these two types of leverage in foreign exchange trading.
Suppose an investor has an initial capital of 3 million yuan in their foreign exchange trading account.
In cases where only “off-exchange leverage” is involved:
By leveraging funds through an over-the-counter arrangement at an interest rate of 10%, the investor borrows an additional 3 million yuan. Since there is no margin trading system in place, the amount available for trading in the investor’s account at this point is 6 million yuan, which represents a 1x leverage multiple compared to the initial capital.The investor uses the leveraged 6 million yuan to purchase the underlying asset and open a position, with a 100% position size.① If the price of the underlying asset moves 10% in the investor’s favor, the investor realizes a paper profit of 600,000 yuan. After deducting the 3 million yuan borrowed, and disregarding interest costs, the investor’s net return on investment is 20% (600,000 / 3,000,000 = 60%).② Conversely, if the price of the underlying asset fluctuates by 10% in a direction unfavorable to the investor, the investor incurs an unrealized loss of 600,000 yuan. By the same logic, the investor’s return on investment is -20%.
It follows that, when only OTC leverage is involved, the gains or losses an investor realizes by adding OTC leverage will be a multiple of the gains or losses realized on their original capital; this multiple is equal to the leverage ratio (in this example, 600/300 = 2x).
In cases where only “on-exchange leverage” is available:
Assuming a margin trading system is in place (i.e., exchange-based leverage exists), with a foreign exchange margin requirement of 10%,an investor uses 3 million yuan of their own capital to purchase the underlying asset and open a position, which represents 100% of their capital. However, because this is margin trading, the investor can ultimately purchase 30 million yuan worth of the underlying asset.
① If the price of the underlying asset fluctuates by 10% in a direction favorable to the investor, the investor has an unrealized gain of 3 million yuan, and the investor’s rate of return is 100% (3,000,000 / 3,000,000 = 100%).② Conversely, if the price of the underlying asset fluctuates by 10% in a direction unfavorable to the investor, the investor incurs an unrealized loss of 3 million yuan; by the same logic, the investor’s rate of return is -100%.
It follows that, under a margin-only system (i.e., where exchange-based leverage is available),the gains or losses an investor realizes through the use of exchange-based leverage are multiplied relative to the gains or losses that would have been realized with their original capital. This multiplier is equal to the leverage ratio applied (i.e., the reciprocal of the margin ratio; in this example, the margin ratio is 10%, which corresponds to 10x leverage).
When both “off-exchange leverage” and “on-exchange leverage” are present:
Assuming a margin trading system is in place (i.e., exchange-based leverage exists), with a forex margin requirement of 10%, an investor uses 6 million yuan—leveraged funds—to purchase the underlying asset and open a position, representing 100% of the position. Since this is margin trading, the investor can ultimately purchase 60 million yuan worth of the underlying asset.① If the price of the underlying asset fluctuates by 10% in the investor’s favor, the investor realizes a paper profit of 6 million yuan. After deducting the 3 million yuan borrowed by the investor—and disregarding interest costs—the investor’s rate of return is 200% (6,000,000 / 20,000,000 = 200%).② Conversely, if the price of the underlying asset fluctuates by 10% in a direction unfavorable to the investor, the investor incurs an unrealized loss of 6 million yuan. By the same logic, the investor’s rate of return is -200%.
It follows that when both off-exchange leverage and on-exchange leverage are present, the gains or losses realized by investors are magnified several times compared to those based on their original capital; this multiplier is equal to the “off-exchange leverage ratio” דexchange-based leverage ratio” (in this example, 2 × 10 = 20 times).
However, in actual forex trading, in addition to the funds used for trading, a forex trading account must also hold a certain amount of additional funds to cover the risks associated with the account’s trading activities.For example, consider an account with $15,000 in equity used to buy (or sell) 1 lot of GBP/USD (where 1 standard lot is worth $100,000 and each pip is worth $10). Assuming a margin requirement of 10%—which equates to 10x leverage—this trade would tie up $10,000 in funds,leaving $5,000 in available account funds. At this point, the account can withstand a risk of 500 pips (5,000 / 10 = 500). When the market price moves in an unfavorable direction and losses reach 500 pips, a margin call is triggered, and the system will forcibly close the investor’s position.
Therefore, the more funds you have in your forex trading account, the higher your risk tolerance will be. The leverage ratio in forex trading merely amplifies the size of your trades, thereby multiplying both the potential returns and risks; however, the actual risk still depends on the size of your open positions in the account!
In addition, since brokers generally do not want to expose themselves to significant risk, they often impose certain limits on the leverage they offer to investors. For example, they may provide higher leverage to clients with smaller account balances, but they typically do not offer high leverage to clients with large account balances.
Let us help you build the perfect forex brokerage firm!
Build your forex business using our cutting-edge technology. LXSuite provides everything you need to build a brokerage business from the ground up. Choosing our reliable and comprehensive software solutions allows you to focus on doing your best.
Offer your clients the world’s most popular forex trading platforms through our MT4/5 white-label solutions, using either your own brand or ours.
