Leverage is one of the reasons why so many people get fascinated to Forex trading compared to other financial instruments. In Forex, you can usually get much higher leverage than you would with stocks.
Sure, many traders have heard of the word “leverage”. But only few know its definition, how leverage works and how it can directly impact their bottom line. In this article, we will focus entirely about leverage in Forex trading.
Leverage involves borrowing a certain amount of the money necessary for investing in something. In the case of Forex, that money is usually borrowed from a broker.
Basically, leverage is the ability to use something small to control something big. It also means you can have a small amount of capital in your account controlling a larger amount in the market.
Stock traders will call this trading on margin. In Forex trading, there is no interest charged on the margin used. Plus, it doesn’t matter what kind of trader you are or what kind of credit you have. If you have an account and the broker offers margin, you can trade on it.
The obvious advantage of using leverage is that you can make a considerable amount of money with only a limited amount of capital.
The problem is that you can also lose a considerable amount of money trading with leverage. It all depends on how wisely you use it and how conservative your risk management is.
Leverage in Forex Trading
In the foreign exchange markets, leverage is commonly as high as 100:1. This means that for every $1,000 in your account, you can trade up to $100,000 in value.
Many traders believe the reason that Forex market makers offer such high leverage is because leverage is a function of risk. They know that if the account is properly managed, the risk will also be very manageable. Otherwise, they would not offer the leverage.
Also, because the spot cash Forex markets are so large and liquid. The ability to enter and exit a trade at the desired level is easier than in other less liquid markets.
Leverage is usually given in a fixed amount that can vary with different brokers. Each broker gives out leverage based on their rules and regulations. The amounts are typically 50:1, 100:1, 200:1 and 400:1.
50:1 leverage means that for every $1 you have in your account you can place a trade worth $50.
For example, if you deposited $500, you would be able to trade amounts up to $25,000 on the market using it. It’s not that you should be trading the full $25,000. But you would have the ability to trade up to that amount.
100:1 means that for every $1 you have in your account, you can place a trade worth $100. This is a typical amount of leverage offered on a standard lot account. The typical $2000 minimum deposit for a standard account would give you the ability to control $200,000.
200:1 means that for every $1 you have in your account, you can place a trade worth $200. This is a typical amount of leverage offered on a mini lot account. The typical minimum deposit on such an account is around $300. With $300 you would be able to open up trades up to the amount of $60,000.
400:1 means that for every $1 you have in your account, you can place a trade worth $400. Some brokers offer 400:1 on mini lot accounts. However, be wary of any broker that offers this type of leverage for a small account. Anyone making a $300 deposit into a Forex account and trying to trade with 400:1 leverage could be totally wiped out in a matter of minutes.
How Leverage Can Go Wrong
Although the ability to earn significant profits by using leverage is substantial, leverage can also work against investors. For example, if the currency underlying one of your trades moves in the opposite direction of what you believed would happen, leverage will greatly amplify the potential losses. To avoid a catastrophe, Forex traders usually implement a strict trading style that includes the use of stop orders and limit orders designed to control potential losses.
A Double-Edge Sword
It’s important to note that leverage is often considered a double-edged sword. That’s because large price swings on accounts with higher leverage increase the chances of triggering your stop loss.
With that, most beginner traders might prefer to start off using minimal leverage. This is to get an idea of how to use proper risk management in order to minimize losses. More experienced traders may use higher-leverage accounts to maximize their wins and benefit from that advantages that Forex has.
How to Pick the Right Leverage Level
There are widely accepted rules that investors should review before selecting a leverage level. The easiest three rules of leverage are:
- Maintain low levels of leverage.
- Use trailing stops to reduce downside and protect capital.
- Limit capital to 1% to 2% of total trading capital on each position taken.
Forex traders should choose the level of leverage that makes them most comfortable. If you are conservative and don’t like taking many risks, or if you’re still learning how to trade currencies, a lower level of leverage like 5:1 or 10:1 might be more appropriate.
Trailing or limit stops provide investors with a reliable way to reduce their losses when a trade goes wrong. By using limit stops, investors can ensure that they can continue to learn how to trade currencies. But it limits potential losses if a trade fails. These stops are also important because they help reduce the emotion of trading. Also, it allows individuals to pull themselves away from their trading desks without emotion.
Tips on using Leverage
Clearly, leverage is a very powerful tool when trading the financial markets. However, in order to use it the most effectively, you’ve got to be disciplined and have a set of rules.
With that, it doesn’t wipe out your account. Leverage has made many traders many fortunes so it’s essential you follow these four steps to make sure leverage can work for you rather than against you:
Always Risk Manage
Risk management is the most important part of any type of successful trading. You must learn how to utilize appropriate risk on your trading accounts. With that, you can maximize gains, minimize losses but take advantage of leverage. A very common way of risk managing trades is to only risk 1-2% of your trading account capital.
Always use a Stop Loss
Most markets trade near 24 hours nowadays. Thus, it’s important you set stop losses so the market knows what do with your position when you are sleeping! Using leverage without stop losses could result in huge losses. But using leverage with stop losses and done the right way could result in some decent gains.
Take it easy
Be patient in the markets and don’t revenge trade after a few losses or, add to a losing position. There are thousands of potential trades every single day so an opportunity will present itself. But you’ve got to be in the right state to take advantage of that opportunity that comes your way. Therefore, take it easy, be patient and stay calm.
Use an appropriate leverage level
Choose a leverage amount that’s comfortable for you. Also, choose one that can ensure you stay in the game long enough to reap the rewards. If you use the principles from step one, this should help you on your way. Remember it’s not about quick riches but long term, consistent gains.
Now you know more about the power of trading with leverage. It’s time to incorporate these principles into your own trading plan.
The Bottom Line
There’s no need to be afraid of leverage once you have learned how to manage it. The only time leverage should never be used is if you take hands-off approach to your trades. Otherwise, leverage can be used successfully and profitably with proper management. Like any sharp instrument, leverage must be handled carefully. Once you learn to do this, you have no reason to worry.
Smaller amounts of real leverage applied on each trade afford more breathing room by setting a wider. But it affords reasonable stop and avoiding a higher loss of capital. A highly leveraged trade can quickly deplete your trading account. That is if it goes against you, as you will rack up greater losses due to bigger lot sizes. Keep in mind that leverage is totally flexible and customizable to each trader’s needs.
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