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.

How we can help

We built a broker review section that is specifically designed with the above criteria (and more) in mind. We have listed all the information you could possibly want to know about each broker in order to help you choose the right broker for your individual needs. This is the most detailed information you will find anywhere, because we have thoroughly tested each broker with real money accounts. We keep adding new broker listings all the time, so check back every once in a while. We hope you find it useful.

Test-run the Platform

All forex brokers nowadays offer traders the ability to test their trading platform with a demo account. Before funding a real account, it is highly recommended that you do this. It will give you an idea of how the platform performs. Are there any glitches? Is it stable? Is it fast? Is it easy to use? Is the charting package any good? Does it have the features I need? These are all questions you can answer very quickly when trading on a demo account. What you cannot know from trading a demo account, unfortunately, is how order execution will be on a real account. Execution is always flawless on demo, but this is not representative of the real market and can be vastly different if/when you make the switch to real market conditions. It is also not possible to withdraw the money from a demo account (very unfortunate), so you cannot judge how quickly these are normally processed. The same goes for deposits. The best way to get an idea of this is to have a look at our broker reviews page, where we have tested each broker with a real money account, and given them a 0-5 rating on how good their order execution is, how quick their transaction processing is, and a number of other important facts.

Customer Support

One way to get a glimpse inside your forex broker’s business is to contact their support staff by a variety of methods. Send emails, use live chat, call them, get them to call you, whatever. No matter how small or irrelevant your questions may seem, they are important. Not only because you are a potential customer and you deserve their time and attention, but also because it allows you to judge how committed they will be if you do open a real account with them. If they are unable or unwilling to spend time with you to answer your questions now, then they most likely won’t act any differently after they have received your money. I encourage you to ask as many questions as you can think of, sometimes even ones you know the answers to, just to see if they will lose patience with you or refuse to answer questions that may seem obvious, or that expose their weaknesses. Some brokers get defensive when you ask them about regulation, for example – not a good sign. Make sure you also ask some tough questions about their internal systems, such as how they process orders, if they offset client orders in a higher tier or if they are the counterparty to clients’ trades, ask them about their liquidity providers, withdrawal fees etc (if you are not sure what these things mean, please refer to our "How Forex Brokers Work" article). These are all things that a client has the right to know. Any decent broker has to respect that and give you the answers. There is no reason not to, unless they have something to hide. It is also a good idea to keep a record of all your correspondence with your broker, just in case some disagreement arises in the future.

Leverage

In contrast, an often overestimated factor involved in the appropriate choice of a broker is maximum leverage allowed by the broker. Most forex brokers have a margin requirement of 1% or even lower, which allows for 100:1 maximum leverage – more than enough for any sensible trader, and yet some traders insist on ridiculously low 0.25% margin requirements resulting in 400:1 maximum leverage. This has been the highway to ruin for most who have tried to use anywhere near that much leverage. You don’t have to be a genius to see why, since leverage multiplies your losses as much as your wins. All it takes is a small losing streak and your account is blown. In any case, this is not a lecture on the pitfalls of high leverage. We can address that in another article. Suffice it to say that low margin requirements and the resulting high maximum leverage should NOT be a big factor when choosing your forex broker, with one notable exception. Some traders may feel that it is better to keep only a small percent of their total trading capital with their broker, preferring instead to hold most of it in a bank account where it is insured and collecting interest, while using high leverage to make up for the "shortfall" in their broker account. If the trading account then experiences a drawdown, it can always be topped up from the main pool. This is somewhat more complicated, and can be more costly due to more transactions being made between accounts, while the delay between getting funds from the bank account to the trading account can also be an added cost. The benefits of this do outweigh the downsides for some traders though, particularly ones who have a significant amount of trading capital and do not trade intraday, because the transaction costs and delays then end up being negligible as compared to the total amount of capital and the average timeframe of open positions.

Minimum deal sizes

Another concern, particularly for smaller accounts, is minimum deal sizes. Some brokers only allow you to trade standard lots (100,000), which does not give someone with a $5,000 account very much flexibility when it comes to money management. Money management is a very important aspect of any trading strategy, and the finer “resolution” you can get when calculating deal sizes, the more accurately your money management calculations can be reflected in reality. This is an often overlooked or at least underestimated factor when it comes to choosing a broker, but it is absolutely critical. The best choice for small account holders are the brokers that offer traders deal sizes as small as 1 unit, giving traders maximum flexibility when choosing the size of their trades and positions.

Tradable Instruments

Finally, when it comes to trading style, some forex brokers have a much wider range of tradable instruments than others. In addition to the major currency pairs, some brokers allow you to trade exotic pairs (such as PLN/SGD or Polish Zloty vs. Singapore Dollar) Gold, Silver, Oil or any number of other instruments. You may or may not find these of interest, but if you do, then going with a broker where you can trade your desired instruments is a must.

Islamic Swap-Free Accounts

Another factor could be a broker’s choice to offer Islamic accounts, which do not charge or pay any rollover or swap interest. Traders bound by Sharia Law are not allowed to conduct any business dealing with interest, so some brokers may be off your list as a result. Many brokers offer swap-free accounts, but many also do not. Moreover, some brokers that do offer swap-free accounts may do so only under certain conditions (read extra fees), since such accounts are susceptible to abuse, and brokers are very much aware of that. It should also be noted that the brokers who do offer swap-free accounts to all their traders, with no extra charges, are a great choice for non-Islamic traders as well, if they simply want to short the carry trade - just be careful, as most such brokers are not regulated.

Automated vs. Discretionary Trading Styles

Some broker platforms are also better suited to automated trading. For example, MetaTrader 4 (MT4) is a favorite among retail traders who program their own “Expert Advisors” or “EAs”. If that’s you, then this could be a determining factor when choosing a broker. On the other hand, if you are a discretionary trader who bases trading decisions on a combined technical and fundamental analysis approach, then it may not matter to you whether the broker offers MT4 or not, as long as the platform offers you good charting. You can visit our broker reviews page for details on which brokers use which specific trading platforms.

Timeframes

OK, so your broker has passed the “legitimacy test”. They are regulated, well capitalized, and they don’t mix client funds with operating capital. Now it’s time to make sure that they provide the type of trading conditions that suit your trading style. Depending the timeframes that you trade, it may be important for spreads/commissions to be very low. Also, if you trade very short timeframes (scalping) you should make sure that your broker doesn't have a problem with that. Generally, brokers who are market makers will have a problem with it, while brokers that use straight-through processing or actual ECNs generally don't mind. Please read our "ECNs vs. Market Makers" article if you are not sure what that means. If you are a day trader, then your transaction costs can make you or break you. If you enter and exit the market several times per day, these costs really add up. Consider, for example, that you are trading 1 mini lot (10,000), 5 trades per day on EUR/USD. If the spread your broker offers you is 3 pips on average, then you are paying $3 per trade, $15 per day, $300 per month etc… you get the picture. If you instead had a broker that offers you an average spread of 1 pip on EUR/USD, then you would be paying $1 per trade, $5 per day, $100 per month! That’s a difference that anyone serious about their business should not ignore.

Regulation

Finally, as far as legitimacy is concerned, it is always prudent to check the WHOIS database for the broker's domain name. If the contact information they provide is misleading, such as a virtual office, or hidden using a privacy protection service such as PrivacyProtect.org, it should immediately raise flags. Any serious business should freely display their real contact information instead of hiding it.

Regulation

Furthermore, if the broker does keep client funds segregated, it is certainly a bonus, since it provides additional protection of client funds even in case of insolvency. FSA regulated brokers, for example, are required to keep client funds segregated. This of course begs the question, where are the funds being kept? Are they in a safe account at a large bank or some dodgy private bank in the Cayman Islands? You can find answers to these questions in our broker reviews section. Alternately, the broker’s customer support should be able to answer these questions. If they cannot, they may be hiding something (or the customer service rep may simply be incompetent - either way it's not a good sign).

Regulation

The first thing you need to do is check whether the broker is regulated. The fact that the forex market itself is not regulated opens the door to a lot of possibilities for a scheming mind. There are shifty brokers out there, ranging from outright scams to just badly run businesses which are not accountable to any regulatory body. The brokers who are regulated choose to be so, in order to add a layer of legitimacy to their reputation. Please do NOT fund any accounts with an unregulated forex broker. There are not many good reason to do so, and plenty of reasons not to. It just makes sense.

How to Choose a Forex Broker

Choosing a good forex broker is one of the most important decisions you need to make at the beginning (or at any point) of your forex trading career. Do not take this decision lightly, but at the same time don’t stress over it – the process does not need to be complicated – just like in your trading decisions, once you do your homework, things tend to fall into place. Chance favors the prepared trader and everything you need to make an informed decision is listed right here. All you have to do is follow the advice given and you will find yourself a broker that suits your needs. If you are not familiar with what is available, you can have a look at the brokers we have listed in our Broker Reviews section to familiarize yourself with who is who in the forex world. If you have already narrowed down your search to just a few, or even one broker, and want to be sure that they are in fact what you want, then keep reading.