Using Forex leverage – What You Should Know
All Forex traders are using leverage while trading instruments in the foreign exchange market, but not all of them truly understand what Forex leverage is, its advantages or the most important factor of using it, which is the risk. So, what is Forex Leverage?
Most of the traditional traders (that are buying and holding positions) are using cash. It means that if they want to buy 100,000$ worth of stock, they must have at least 100,000$ in cash in their trading account. Professional traders are using a relatively low leverage, which means that if a trader wants to go long with $100,000 worth of stock, he needs around $30,000 in cash in his trading account (the trader uses only a partial amount of the amount that he wants to trade).
So basically trading in the currency market using Forex leverage, is trading on credit. While Depositing a small amount of real money and then opening a relatively large position, you actually borrows a larger amount of funds from the broker itself.
Example – in order to open a trade of 1 lot without using Forex leverage, you, as a trader, must have a minimum of 100,000$ in your trading account. However, with a leverage of 1:100, you can open this trade size with only 1,000$, as the broker will borrow you additional 99,000$ in order to give you the possibility to open the position. When you open such a trade, 1,000$ of your account will be used as margin, and the rest is considered as a leveraged amount. You may ask why would brokers do such a thing.. Well, they want you to trade. They makes commission from each transaction, and protect themselves by using your margin. The position will be automatically closed when you reached a certain percentage (usually 25%) of your overall margin. That way your account will not drop below zero, and the broker is not risking its own funds.
Forex Leverage is an Efficient Use of Capital
In the reality, professional traders are using Forex leverage in every position traded because it permits to manage their capital efficiently. There are many advantages in leveraged trading, but there are risks involved too. Trading using leverage, allows traders to enter markets that would be unavailable for them, and without the required high minimum deposits.
Using leverage in the foreign exchange market, also allows you to open more positions and contracts of certain indices, futures, or currency pairs. The leverage itself is not necessarily increases the risk of trading. Forex leverage is risky only for beginners and traders that are not well-educated in risk management strategies.
The following example of a EUR/USD trade shows why the usage of leverage in forex trading not incurs higher risk than traditional trading when you use it properly.
⦁ Symbol: EUR/USD
⦁ Trade: Long 1 Lot
⦁ PIP Value: 10$ per 1 pip
⦁ Entry Price: 1.30000
⦁ Take profit Target: 1.30500
⦁ Stop Loss: 1.29800
If the above trade is traded without any Forex leverage, a trader would need $100,000 in order just to open the trade. If the trade goes upward, and reaches the take profit target, he would make a profit of 50 pips, and earn $500 (50 pips x 10$ per pip). In case the position was not profitable and reached the stop-loss level, he would lose 20 pips, and therefore lose 200$ (20 pips x $10 per pip) of the original capital. If the same trade is executed while using Forex leverage, the same trader would only need 1,000 in his trading account balance in order to enter this EUR/USD position. If the trade was profitable, he would make the same profit of 50 pips, which are still 500$ (50 pips x $10 per pip). If the trade goes against him, he would still lose only 20 pips, which will be again equal to the same 200$ loss (20 pips x $10 per pip).
The profit or loss outcome of this trading position is exactly the same regardless of whether the trade is made using only balance with no leverage, or trading with a leverage, because the position size is the same in both cases – 100,000$ (1 LOT).
Many traders believe that using Forex leverage in your trading is very risky, the fastest route towards losing your money. This might be true when an inexperienced trader works with 1:500 or similar leverages, opening 1 lot position on the EUR/USD pair with a minimum account of 200$. The market then needs to move only 20 pips against him in order to burn his account. Of course that it applies to both directions, as if the market favor his direction and pass of 50 pips, the 200$, can become 700$ in just a few minutes. But even though the Forex platform is very tempting, don’t play with it. I believe that you didn’t come here to gamble. If so, it’s better to go to the casino. At least there you will enjoy some free drinks and beautiful women..
Conclusion About Using Forex leverage
Using Forex leverage, as I wrote, is a very efficient way to manage your funds.
It is not that risky as a lot of traders believe, and actually can reduce risk if you use it wisely. So be reasonable, don’t avoid it, but use it as another tool to improve your performance. While using a decent risk management system you can enjoy one of the biggest advantages this market has to offer.