Lots of people new to trading get confused by the concept of leverage in Forex, how it is calculated and how it should be used. If you are just starting out trading, you should approach leverage with caution because this very powerful tool can also work against you.
The Basic Concept:
If you open up a standard Forex account with most brokers, you will find they deal in lot sizes of $100,000. To make a single trade with your account, you are going to need $100,000 to place on it. There are not many of us that could afford this, and so leverage is offered by brokers to traders.
To allow people to trade these large lot sizes, brokers will effectively loan you money to place the trade provided you give them a percentage of the trade as a security against it. Should your trade move against you by more than what you gave the broker as security then you are out of the game and your money lost, should it move your way then you should make a good profit.
More Details On Leverage In Forex:
The standard format for expressing how much leverage a broker offers is as follows – 100:1. In this example, it means that for every $100 traded you need to provide $1 security (1%). Similarly, 200:1 means they are offering trades with only 0.5% security (1 / 200 * 100(%)) and so on. You may see brokers go as high as 400:1 (0.25%).
Another term that is often used in the company of leverage is the word ‘margin‘. The margin is always expressed as a percentage, and it is the figure that represents the percentage of the trade required as security. In the case of 100:1 leverage, the margin is 1%. Forex margin trading and leverage trading are generally used interchangeably to refer to the same thing.
Leverage In Use:
From the examples above it should now be clear that leverage could allow you to borrow $99,000 form your broker to make a $100,000 trade, with only $1000 of your own money at risk. As mentioned previously though, your trade will get closed by your broker if it falls by the $1000 security you used. Once your $1000 is wiped out, the broker isn‘t going to risk his money on your trade if it continues to fall.
If you trade with a margin of just 1%, the trade needs only to drop by this small amount to get wiped out. Due to the volatile nature of the market, it is entirely conceivable that a trade with a good probability of turning a profit will move in the wrong direction by 1% or more first. Your small margin for error meant you lost your stake because your broker had to close the trade too early, this is commonly referred to as being too heavily leveraged.
Avoiding Small Margins And Heavy Leveraging:
Follow this link to learn more about forex trading strategies that don’t put you at risk of being too heavily leveraged, which is vital in protecting your trading account.
It is possible to use leverage in forex trading to make profitable low risk trades, as long as you know how to use this tool in a responsible manner.
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