One of the reasons why so many people prefer forex to other financial products is that you can generally achieve considerably more leverage with forex than you can with stocks. While many traders are familiar with the term “leverage,” few understand what it means, how it works, and how it may affect their bottom line.
The notion of entering a transaction with other people’s money may also be extended to the FX markets. In this post, we’ll look at the advantages of trading with borrowed funds and why utilising leverage in your forex trading strategy might be a double-edged sword.
Defining The Concept Of Leverage
Leverage is when you borrow a portion of the money you need to invest in something. Money is generally borrowed from a broker in the case of FX. Forex trading does provide significant leverage in the sense that a trader may build up—and control—a large amount of money for a little starting margin need.
Simply divide transaction cost by the amount of margin you must put up to determine margin-based leverage:
For instance, if you must deposit 1% of the whole trading volume as margin and want to trade one standard lot of USD/CHF for $100,000, the margin necessary would be $1,000. As a result, your leverage will be 100:1 (100,000/1,000). Using the same method, the margin-based leverage for a 0.25 per cent margin requirement is 400:1.
Contrarily, margin-based leverage doesn’t necessarily reduce risk, and whether a trader has to put up 1% or 2% of the whole value as margin may not affect profits or losses. In this scenario, it’s because the investor may constantly overestimate the required margin. This suggests that genuine leverage, rather than margin-based leverage, is a better predictor of profit and loss.
Simply divide the entire face value of your active positions by your trading capital to find out how much leverage you’re presently using:
For instance, If you do have $10,000 in your account and establish a $100,000 position (equal to one standard lot), your account will be leveraged 10 times (100,000/10,000). It is possible to increase your account leverage by 20 times if you have two standard lots with face values of $200,000 and $10,000 in your account.
So the most leverage a trader may use is the margin-based leverage. Because most traders do not utilise their whole account as a margin for each transaction, their real leverage differs from their margin-based leverage.
A trader should not, in general, employ all of their respective margins. A trader should only utilise leverage when they have a big edge.
It is feasible to calculate the potential capital loss if the amount of risk in terms of pips is understood. This loss should never exceed 3% of your trading capital as a general rule. If a position is leveraged to the extent that a loss of 30% of trading capital is possible, this method should be used to lower the leverage. Traders will have their degree of experience and risk tolerance, and they may opt to depart from the 3 per cent general rule.
Traders can also figure out how much margin they should utilise. Let’s say you’ve got $10,000 in your trading account and want to trade 10 micro USD/JPY lots. In a mini account, a one-pip move is valued at around $1, but when trading ten minis, each pip move is valued at about $10. Each pip shift is worth roughly $100 if you’re trading 100 minis.
The loss of $30 for a single mini lot might be $300 for ten mini lots and $3,000 in the case of 100 mini lots when the stop-loss is 30 pip. As a result, even if you can trade more, with a $10,000 account and a 3% maximum risk each trade, you must only leverage up to 30 mini lots.
Leverage In Forex Trading
Leverage in the foreign currency markets is often as high as 100:1. This implies you may trade up to $100,000 in value for every $1,000 in your account. Many traders think that the high leverage offered by forex market makers is since leverage is a factor of risk. It’s clear to them that if the account is well-managed, the risk is well-managed, or else they wouldn’t lend them money out at all.
We track currency fluctuations in pips in trading, which is the smallest variation in currency price and varies per currency pair. These changes are in the tenths of a penny. For example, if the GBP/USD currency pair changes 100 pips from 1.9500 to 1.9600, the exchange rate has only moved 1 cent.
This is why currency transactions must be conducted in big volumes, allowing minute price changes to be converted into higher gains when leverage is used. When dealing with a large sum of money, such as $100,000, even little fluctuations in the currency’s price might result in huge gains or losses.
High Real Leverage In Forex Trading Pose A Risk
This is where real leverage becomes a double-edged sword since it can magnify your gains or losses by the same amount. The more leverage you apply to your capital, the larger the risk you will take. It’s important to note that this risk isn’t always linked to margin-based leverage, but it can have an impact if a trader isn’t attentive.
The Bottom Line
Once you’ve figured out how to manage leverage, there’s no reason to be frightened of it. The only time you should utilise leverage is if you take a hands-off approach to trading. Otherwise, with good management, leverage may be used productively and profitably. Leverage, like any sharp tool, must be handled with care; once you’ve mastered this, there’s no need to be concerned.
Smaller actual leverage applied to each trade gives you more breathing room by allowing you to set a broader but appropriate stop and prevent a larger capital loss. If a heavily leveraged transaction goes against you, the larger lot sizes will result in larger losses, quickly depleting your trading account. Remember that leverage is adaptable to the demands of each trader.