Most brokers these days advertise leverage as one of the selling points of opening an account with them. In simple terms, leverage in the Forex world refers to the ability to control large trading volumes with a small investment. It is commonplace to find brokers advertising leverage of 100:1. Simply put, your broker will allow you to trade 100 times what you actually deposit.
In this example, the broker is saying that he will ‘lend’ you the money to make your trade, if you put forward 1% of that trade as a security against it. That 1% is called a margin: the percentage of the total trade required as collateral. This 1%, when expressed as leverage becomes 100:1 (a security of 1 is required for every 100 traded). You will even find brokers who are willing to give you a higher leverage, even up to 400:1 (meaning they require only 0.25% security).
So by using leverage as a forex trading strategy, it is possible to fund an account with just $1000 and you could control trades valuing up to $100,000 (assuming the leverage is 100:1). For someone looking to start a career in Forex trading, but has limited funds to begin with, this would seem like a gift from heaven.
One key element that many brokers may neglect to mention, is that the leverage they quoted is actually the maximum available to you. You don’t actually have to use all of it. The truth is that you should rarely, if ever, use the maximum quoted leverage. The reason is that the more leverage you take the more at risk you become.
Using the previous example of buying a lots of $100,000 with a 1% margin (leveraging your $1000 by 100%). You now have open trades worth $100,000, but only a breathing space of $1000. If your lots fell in value by a mere 1%, your $1000 would be wiped out and your broker would make a ‘margin call’ (this means some or all of your trades would be closed automatically).
Putting in place a stop loss is a common tactic used here, but with this much leverage you will only give yourself even less room to breath. Then we have the spread put in place by your broker, now you find yourself with very little room to manouvre. Yes I am being negative, and it is possible your trade will turn a profit. The problem is that due to the volatility present in the market, it is not unusual for a trade to move a little against you before turning profitable. Because you were too heavily leveraged, your trade closed at a loss because you had no room to breathe.
Sensible traders will not leverage their accounts too heavily. Instead of taking the maximum 100:1 on offer, a much more level-headed option would be to take say 20:1 (which would be a 5% margin).
With this example, you would now control lots to a value of $20,000, and they would have to fall by 5% in value for your broker to make a margin call. You can now place a stop loss that gives you room for a possible dip without your trades closing out before they turn into profit.
Forex trading leverage will always be a good way to let traders use the market to their advantage with minimal risk, but when used recklessly then a slight move against you could see your trading balance wiped out very quickly. When used correctly, a leveraged account gives the average man in the street the opportunity to trade in lots that would have otherwise been out of his reach. When using leverage in your trading it is vital that you do not leverage your account too heavily and that it should be used as a tool to give you an advantage in the market, not your broker.
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