Understanding Leverage BEFORE You Trade Forex!
Leverage is an incredibly powerful tool in the right hands — but it’s also incredibly dangerous to inexperienced traders.
Virtually all large forex brokers will offer you leveraged trading, but you need to understand the ramifications of trading with leverage before you trade forex. Leverage allows you to effectively trade more money than you have in your account, increasing your profits and your risks.
What is Leverage and How Does it Work?
Leverage effectively multiplies the amount of money that you have to trade. It is generally expressed as a ratio, such as 10:1, which would indicate a leverage of 10 trading dollars for each 1 dollar that you have. This is a very modest amount; most brokers will offer a leverage ratio of 50:1 to 200:1, depending on the size of the account and the broker.
Traders can also opt out of using leverage if they want to, but this can severely limit their earning potential. When trading on a leveraged account, you will have the amount that you can trade and the actual cash value of the account.
Leverage doesn’t affect the amount of cash at hand, only the amount of cash that you the trader can have tied up in trades at any given time.
What are the Benefits of Leverage?
As any trader knows, a reliable forex trading strategy will generally make a percentage of profit over time.
Lets say a trading strategy is performing at a level of 12% to 15% profit over the course of a month. This makes the amount of money that a trader starts with extremely important.
A trader that is trading $1,000 on a 1:1 (no leverage account) would make only $120 to $150 a month with this strategy.
A trader with a 1:100 leverage, however, would be able to make $1,200 to $1,500 a month with the same amount of money and the exact same strategy.
Leverage essentially allows a trader to get a head start in their trading and to remain more flexible as their trading progresses.
The forex market is the only popular, high volume market that commonly allows such significant leverage ratios.
Equities and stocks generally won’t go above a leverage amount of 2:1. But this is because the forex market is actually far more stable than any other market; most currencies don’t fluctuate significantly the way that stocks or other forms of equity do. Thus, using leverage on the foreign exchange market is safer than using it on any other market.
That being said, there are still some major concerns regarding leverage. Though these concerns don’t outweigh the benefits, they still need to be considered, especially by traders who are new to the market.
What are the Dangers of Leverage?
Leverage acts as a modifier on an account.
Not only does it enhance potential profits, but it also enhances potential risks; it is for nearly all intents and purposes like trading with a much larger account.
Amplification of profit and loss
However, there is one major difference, and understanding this difference is critical to success. An account’s losses can never exceed its cash balance. When it does, this results in a margin call, and all of the trader’s orders– even the ones that are losing value — are closed at once.
This can be devastating to traders that aren’t using appropriate cash management. Every account has a margin level.
This margin is the minimum maintenance amount of the account, which is set by the brokerage using an algorithm. Usually it’s anywhere from 25% to 50% of the value traded in your account. Though a margin functions even without it, it becomes far easier to hit when leverage is in play.
A trader may have a trading account of $1,000 that is leveraged 100:1. Their margin may equate to half that — $500 or so.
Therefore, you can initiate a order of $10,000 without much issue. If that trade order gains $1,000, you will be able to close the trade and take that profit. But if it loses $500, the order will immediately close and take the loss.
Suddenly you have only half their money to continue trading. It’s extremely easy to wipe out an account with leverage, and inexperienced traders make this mistake all the time. Though you may not be foolish enough to ride a single $10,000 trade into $500 in losses, you may initiate many orders that combine into $500 in losses.
This can occur quite suddenly, if the trader has a few orders open that relate to the same currency, such as a USD/JPY and a EUR/USD order — if USD fluctuates severely, then losses can accumulate quite fast.
How Can You Properly Trade With Leverage?
Proper trading with leverage is all about account and cash management.
Forex traders need to make absolutely certain that they aren’t trading too much of their account. Traders have to be able to take their losses rather than ride them and you need to have consistently set stop losses to make sure that your account doesn’t suddenly plummet due to changes in market temperament.
Traders have to keep their leverage in mind constantly; there should never be a risk of a margin call. Furthermore, you need to diversify trades; if you are initiating multiple trades, you shouldn’t be trading the same currencies in the same direction. Instead, you should at least be hedging their bets.
Working with leverage also means continuously updating yourself on the status of your account. Losing tra
ck of your account is a sure way to eventually experience a margin call, as is not setting appropriate take profit and stop loss amounts.
As with most aspects of forex trading, using leverage is about discipline. Without discipline even a winning strategy isn’t going to result in consistent profits. A forex trader needs to be very conscientious about opening new trades and should only be trading a percentage of their account at any given time – not risking the entire account!
Leverage isn’t just a useful tool in forex trading — it’s an essential one.
Currency pairs move quickly, but they also don’t fluctuate in value as much as many other types of investment. By maximizing leverage, traders are able to make more in profit. Unfortunately, this also potentially increases losses.
With proper account and cash management in addition to a winning strategy, leverage can create fast profits — and with inexperienced trading and poor cash management, it can entirely wipe an account within minutes. To become a successful forex trader you will need to learn about working with leverage and put it into practice on a demo account before diving into real trading.
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