Forex leverage represents credit facility enabling a trader penetration in the trading contracts that require huge investment while having a nominal amount of real cash available in his trading account.
Forex Leverage is the amount of money obtained through credit commonly provided by the brokers. Leverage ratio established on the agreed amount of marginal account deposit that is mutually agreed between the investor and broker at the time of opening a forex trading account. Leverage ratio depends on the margin ratio. 100:1 leverage means that for every $1 a trader can put a trade worth $100.
For example, for putting the trade amounting to $100,000 a trader needs to have $1000 in his account by using the 100:1 leverage.
Forex Leverage is the amount of money obtained through credit commonly provided by the brokers. Leverage ratio established on the agreed amount of marginal account deposit that is mutually agreed between the investor and broker at the time of opening a forex trading account. Leverage ratio depends on the margin ratio. 100:1 leverage means that for every $1 a trader can put a trade worth $100.
For example, for putting the trade amounting to $100,000 a trader needs to have $1000 in his account by using the 100:1 leverage.
How to work with forex leverage wisely
Leverage has the ability to make bigger profits but it also has the capacity to enlarge the losses by the same proportion. High leverage represents higher exposure to risk. So it should be used very carefully and wisely.
Diversification
A trader should devise the strategy for utilizing the leverage facility wisely. Leverage facility permits the traders to acquire access larger amount of capital but it’s not reasonable to intact the whole facility with the single transaction. That means carefully applying the diversification strategy by using the small trading lot sizes.
Example:
A trader has $5000 capital in his account. On the basis of 100:1 leverage the trader can open a trade worth of $500,000. Let’s suppose;
- The trader opens a trade amounting to 300,000 number of units (3 standard lots) by investing in EUR/USD.
- Pip value assumed $100 for single standard trade lot.
- If the trade close out after losing the 10 pips.
- The trader will lose $3000 ($100 pip value x 10pips x 3 standard lots) just in one go.
On the other hand, if the trader uses the leverage wisely and uses the base capital by investing in small trading lots in different pairs, the result would be less harm. One major benefit of the diversified portfolio is that if one investment makes a loss, the profit from other investments will set-off this loss and the end position of the trader is quite stable. The lesson of the diversification is that do not put all the eggs in one basket.
Stop Loss
Stop loss order is another very effective technique used to minimize the exposure to risk. The technique is used to limit the trading loss and its limit is determined by the trader. For example, the EUR/USD opening trading position is $1.1245 a trader can limit the loss on this particular trade by setting the stop loss order at $1.1238. The trade was automatically close when the pair price touches that amount i.e. $1.1238.
Leveraging Profits
In the case of favorable position in an ongoing open trading i.e. when a trader making a progressive profit in the present forex trading and he believes that this situation continues to some extent of time. The use of leverage at this moment enlarges the profit of the trader.
Using leverage is for sure a good way to make a big amount of money with forex trading, but it is also a great way to lose a lot of money.
It is sort of a double edge sword if you like, it plays for you as well as against you.
You must be extremely careful when playing with leverage because it has the power to generate huge losses that can exceed your original deposit!
It is sort of a double edge sword if you like, it plays for you as well as against you.
You must be extremely careful when playing with leverage because it has the power to generate huge losses that can exceed your original deposit!
First things first, let’s introduce what leverage exactly is.
Fundamentally, leverage is just credit.
In forex trading, leverage is money that your broker lends you in order for you to be able to trade with larger capital than you originally invested.
If used correctly, of course, leverage will boost your profits, while keeping losses under control. But if used recklessly leverage may very well kill your entire investment in one shot.
Let’s take an example to better understand what we mean here.
Fundamentally, leverage is just credit.
In forex trading, leverage is money that your broker lends you in order for you to be able to trade with larger capital than you originally invested.
If used correctly, of course, leverage will boost your profits, while keeping losses under control. But if used recklessly leverage may very well kill your entire investment in one shot.
Let’s take an example to better understand what we mean here.
How Leverage in Forex Trading Works
If you invested 10,000 USD with a forex broker and you use the most commonly used leverage of 100:1, then, you are automatically entitled to 1,000,000 USD in trading capital. The maximum size of trades you can open in USD terms is your investment multiplied by the leverage, and in this case, that is 1 million US Dollars. Whether you use it all on one trade or on multiple trades does not matter.
Because the credit money is borrowed from the broker, it normally follows that an initial deposit is required in order to cover for the credit. This is done on a per trade basis, that is, on each opened trade the broker takes a portion of the trader’s equity and provides the rest of the money calculated based on the leverage set.
This is known as margin and is always a percentage of the leverage used. In the previously given example, for a 100:1 leverage the margin is 1% because 1÷100 = 0.01. That simply means for each opened position the trader only needs to provide 1% of the funds and the rest will be provided by the broker.
Because the credit money is borrowed from the broker, it normally follows that an initial deposit is required in order to cover for the credit. This is done on a per trade basis, that is, on each opened trade the broker takes a portion of the trader’s equity and provides the rest of the money calculated based on the leverage set.
This is known as margin and is always a percentage of the leverage used. In the previously given example, for a 100:1 leverage the margin is 1% because 1÷100 = 0.01. That simply means for each opened position the trader only needs to provide 1% of the funds and the rest will be provided by the broker.
Determining a Good Leverage Ratio
So, if you can trade a million dollars does that mean you should and does that make you a millionaire?
The answer is, of course, NO to both questions. Taking into account that the “lot size” is the basic unit of measurement for “trading volume” in the forex market it logically follows that this element is fundamental to calculate eventual profits or losses on each pip won or lost. If for example, you choose to use a 100:1 leverage and you trade 2,5 lots with your 10,000 USD, every pip would be equal to approximately 25 USD. Considering that the daily volatility for most forex pairs is approximately 100 pips, you could lose up to 2,500 USD, almost ¼ of your initial deposit in just one trade. In order to effectively limit this risk, a good strategy is to start with smaller lot sizes, such as 0.1 (1 mini lot) or maybe 0.2 if you are more risk-hungry. This way you can limit your losses and manage your money in a wiser way. Essentially, the number of lots together with leverage is everything when it comes to the risk in forex trading. The number of lots you take on your trades control the size of your positions, while leverage gives you the ability to take big positions. Naturally the bigger the position the greater your risk is.  What it takes on a percentage basis to make up for the losses in your account! Just because you have the ability to open larger positions that does not mean you should. In fact, you can have your leverage set at 100:1 or 200:1 and still trade with micro lots (size 0.01), even in a 10,000 USD account. Each position in this situation will be approximately 1,000 USD or 10% of your deposit. Each pip will be worth around 0.1 USD which means on a 100 pip move your maximum risk is 10 USD. Adjusting Leverage is also an OptionAlternatively, if you do not think you can control yourself by trading with small lot sizes, you can set your leverage at a very low level like 1:2 or 1:5, or even 1:1 (in which case you would be trading without any leverage). Professional traders use low leverage ratios normally, and there is no reason this to not be the practice of retail traders as well. Most professional forex brokers should provide the option to adjust the leverage online and in a few clicks. When you start out in trading you can opt for a very low-risk approach by using no leverage and then as you become more confident you can start to introduce some low leverage ratios. Never underestimate the volatility of the market and make sure you calculate exactly how much a single pip is worth on each currency pair that you intend to trade. If you are unsure about any part of how lot sizes or leverage affect your account then, by all means, do not use leverage until you have fully grasped these concepts. You can also find more useful information in our money management guide or our pip and position size calculators will help you when determining correct volume for your trade. Lastly, if you are a complete beginner, consider that losing trades will most likely be more frequent and bigger than the winning trades. That’s why it is even more important to stick to a low leverage when you are entering the world of trading and then increase it when you gain enough experience and confidence in your strategy. Always keep in mind, abusing leverage will sooner or later erase your entire account! |
