One of the biggest advantages of Forex trading is leverage, and it can make you a whole bunch of money if used correctly. The level of financial leverage remains a major draw for traders to choose the FX market. But before making leverage work in their favor, two questions that may bother rookie traders are:
1. What is leverage?
2. How can it be useful?
We try to answer these fundamental questions and hopefully you’ll be better equipped to make smart use of leverage after reading through this article.
What is leverage?
In simple terms, leverage refers to using a small amount of one thing to control a large amount of something else. Specific to Forex trading, leverage is the borrowing of capital to increase your returns on investment. It means that you can have a small amount of capital in your account but control a much larger amount in the Forex market. Since nothing is better explained with an example, here we go:
If a Forex broker offers you a leverage of 100:1, this means that for every $1 you have in your account, you can place a trade worth $100. So if you have $1000 in your account, you can control a $100,000 position.
Similarly, for a leverage of 200:1, you can place a trade worth $200 for every $1 in your account.
The concept of leverage also ensures that even traders with little capital to invest can place significantly larger traders and get higher returns on their investment. But leverage works in two ways, and losses can mount in a hurry when a trade goes wrong. We’ll get back to that a little later.
How leverage works?
If a trader has $1000 in his account, and a leverage of 100:1, he can trade a position that is as large as $100,000, or 1 standard lot. Now let’s say that the $100,000 investment rises in value by $1000 i.e. $101,000.
Now without leverage, the trader would have had to invest the entire $100,000 which would have resulted in a rather meager return of 1%. Since he is leveraged 100:1, the trader has only invested $1000 and has a big return of 100%. This is where leverage works its magic. It magnifies your gains substantially. So it makes sense to open a trading account with the highest leverage. Or does it?
Pitfalls of leveraged Forex trading
In our example above, imagine if the trader had instead lost $1000. Then what would his return be? Calculating the same way we did earlier, you would have ended up with a -100% return using 100:1 leverage. If your trades move in the opposite direction, leverage will essentially amplify your loss. A common mistake that new traders make is to use leverage with no regard for risk trade. With no concern for downside risk, a few losses in leveraged trading can wipe out an entire account. It is with good reason that leverage is considered a double-edged sword.
What leverage is right for me?
The right amount of leverage to use is subjective, as it mainly depends on your trading strategy and vision of upcoming market moves. As a rule of thumb, we can describe a relationship between leverage and its impact on a trading account. The greater the amount of leverage used, the greater the swings in your account equity. Optimal leverage is crucial to developing a sound trading strategy.
Forex brokers like Trust Capital offer attractive leverage options to traders looking to squeeze the maximum out of profitable trades. As a trader, it is upon you to choose wisely. Just because you have access to a higher leverage does not necessarily mean you have to use all of it.
The obvious advantage of using leverage is that you can make a significant amount of money with only a limited amount of capital. The downside is that you can also lose an equally big amount of money. It all depends on how you use it and how conservative your risk management is.
Finally, if you’re interested to know more how you may use leverage in a smart and profitable way, just complete this one-step registration to our free Wednesdays’ seminars.