How to calculate “true” leverage

The term “true” leverage has been in use recently to differentiate it from the “maximum” leverage that brokers use in their marketing efforts. A few years ago, the word “leverage” would have been sufficient to describe what we are calculating, but retail forex marketing lingo has changed the traditional use of the word.

As we mentioned before, leverage in the financial markets is the DEBT:EQUITY ratio, so we need to calculate our debt and our equity (duh).

Equity is very easy to calculate:

E=B+P

where

E = Equity (the quantity we are trying to calculate)

B = Balance

P = Profit on open positions (negative if open positions are in the red)

Margin requirement

To recap then, the major difference is that the margin requirement is set by your broker, which determines your maximum leverage. How much of that available leverage you use in your trades is entirely your choice. Your broker does not set your leverage. They just set the maximum that you can use. A responsible trader generally never has to worry about this, as the leverage s/he uses is far below the maximum allowed by the broker. Whether a broker’s marketing guys offer you “400:1 leverage” or “50:1 leverage” should not generally make any difference. Let’s see first how to calculate leverage, and then why responsible traders never over-use it.

Margin requirement

So when a broker’s marketing team says their margin requirement is 1%, it means that they require 1% of your trade size in order to lend you the amount you need for the trade. For example if you are trading $100,000 position size, then the broker requires $1,000 (1%) of your margin in order to make the loan. As I stated before, this number generally does not vary unless you specifically change the deal with your broker. Furthermore, in this example we know what the margin requirement is, but we don’t yet have enough information to calculate leverage, because we don’t know what our account equity is (more about this later). Your broker would normally quote that as “100:1” leverage, which is not entirely accurate since our actual leverage also depends on our account equity. What they are actually saying is that your maximum leverage, based on their margin requirement, would be 100:1. How much of that leverage you actually use is entirely up to you, as long as you don’t surpass this maximum.

Margin requirement

expressed as a percentage, the margin requirement is set by your broker to protect itself against traders using too much leverage, or in other words, against traders borrowing more than their collateral would support according to the broker’s risk management parameters.

Leverage

The use of credit or borrowed funds to increase one's speculative capacity and increase the rate of return from an investment, as in buying securities on margin, although it can also increase the rate of loss by the same factor. Your leverage depends on the size of the trades you make relative to your account equity, and nothing else, as long as you don’t surpass the maximum leverage the broker allows. This value is normally displayed as a DEBT:EQUITY ratio.

Margin

The amount of collateral a customer deposits with a broker when borrowing from the broker to buy securities. This is your account balance when you first open your account.

Calculating Leverage in Forex

The concept of leverage is really quite simple, but its true meaning often becomes lost in the mountain of marketing-speak most forex brokers dish out at us traders. The misconceptions always arise as a result of the interchangeable usage of the words “margin” and “leverage”. These two concepts are related, but are in fact not interchangeable except in the most extreme (and suicidal) case where a trader decides to use the maximum leverage available to him under the broker’s house rules.