Back to the Basics
In order to trade in large volumes and increase potential profit, traders borrow certain amounts from the broker. This loan is leverage. It comes in different sizes: 1:10, 1:50, 1:100, 1:500, 1:1000.
To make it clearer how exactly leverage works, let's look at an example.
Imagine you have $10,000 on your account. You want to open a position in 1 standard lot on the EURUSD pair. For this, you need to have $100,000. Let's say your leverage is 1:100. This means that 1/100 of the transaction volume will be used from your account.
$100,000 / 100 = $1,000
A $1,000 from your account will be used as collateral. The remaining $99,000 from the position will be provided by the broker.
It is quite obvious that the broker will not risk this entire loan amount. That’s why the potential losses in your account will be limited by the remaining free funds on your account. What happens in case of a losing trade?
So, the floating loss in your account at the time of opening the transaction is $9,500. If the funds start to run out, the broker asks you to add more money. This action is known as a Margin Call. If you fail to add more funds on time, the broker will automatically close your losing positions in order to secure its own funds. This action is called Stop Out.
Margin Call and Stop Out occur when the funds in your account become insufficient to maintain the collateral. The required volume is displayed as a percentage and depends on the broker and on the account type. If the levels are 70%/40%, then when the funds required to maintain the collateral drop to 70%, the Margin Call happens. When funds fall to 40%, your losing positions begin to close by Stop Out.
What Happens After Closure of Losing Position
Let's get back to our example.
Suppose your position was unsuccessful and closed by Stop Out with a loss of $9,500. The cost of the position will be:
$1,000 (collateral) + $99,000 (loan) - $9,500 (loss) = $90,500
The broker will pick up the $90,500 plus the missing $8,500 to fully recover its $99,000. Thus, the entire loss of $9,500 will be withdrawn from your account and you will be left with $500 only.
What Happens After Closure of Winning Position
If under the same conditions, the position turned out to be profitable (profit of $9,500), then the calculations will be as follows:
$1,000 (collateral) + $99,000 (loan) + $9,500 (profit) = $109,500
After closing the position, the broker will withdraw its $99,000 and your account will have:
$1,000 (collateral) + $9,500 (profit) + $9,000 (untouched funds) = $19,500
Is Risk Increased With Leverage Size?
Yes and no. It all depends on your actions. Leverage allows you to open positions with a large volume. If you take this opportunity to the fullest, then your funds can dissolve in the blink of an eye.
But let's look at a different situation. Say there are two accounts with the leverage of 1:200 and 1:1000. On both accounts, you open positions on the USDJPY pair with a position size of 0.1 lot. In this case, the cost of 1 pip for both trades is $0.93.
If the positions pass 100 points against you, the losses on both will be $93, regardless of the leverage size.
Thus, the high risk of large leverage is a myth. The danger is the lack of a proper risk management system.
To Summarize
If you want to control your risks, then it makes no sense to focus on the leverage size. It’s crucial to control the size of your positions. Before opening a transaction, calculate the cost of one pip taking into account the size of this trade. To simplify the process, you can use a trading calculator.
Knowing in advance the pip value and where you’ll set a Stop Loss, you can calculate how much you might lose. If the amount is too large you should reduce the position size. That’s the whole secret of risk management. High leverage doesn’t play a role here.