What is forex leverage?
Some of you may have an idea on what forex Leverage is. But for the sake of those who may not, we are going to look at
the term once again. In the previous lesson, we learnt that this is the amount of money that is provided to investors and traders by a forex bureau. In other words, it's a form of loan that is given to an investor by the broker who is handling his or her account.
Now let's see how forex leverage works.
In most cases, you are given a leverage of 50:1, 100:1 or even 200:1. This depends on your forex broker as well as the size of your position. The trading that is considered as standard is on 100,000 currency units. In such a case, you are offered a leverage of 50:1 or 100:1. You can only get the 200:1 leverage if your position is below $50,000.
For example, if you intend to trade with currency worth $100,000, with a 1% margin, you will be required to deposit $ 1,000 into your margin account. In such a case, the margin that you are given is of 100:1. As you can see, this size of leverage is quite large when compared to the 2:1 leverage which is given on the equities and a 15:1 leverage that is provided by future market.
But don't you think that this leverage is extremely risky?
The answer is no. This is because the currency prices usually fluctuate by a margin of less than 1%. Otherwise, like you can guess, the brokers would not agree to provide this big leverage.
What does the term margin mean?
Lets look at this question. In order to be allowed to use forex leverage, you will need a certain amount of money. This is usually referred to as the 'good faith deposit'. This amount is usually expressed as a percentage of your position. To find out about the leverage amounts that are offered by different brokers, you can view at our Forex Broker's Guide.
For example, if you intend to control a position of $100,000, the broker sets aside $1,000. This can be termed as a margin of 1%.
There are other types of margins that you will come across in the trading platform such as account margin, used margin, usable margin and margin call. For more details on these types of margins, you can refer to our previous lesson.
What are the advantages of using leverage?
Doesn't it look like a simple way to make money using leverage? Definitely it is and this is one of the reasons as to why most people invest in forex trade. The high leverage is that is provided by the brokers is a big attraction to many. On top of this, with just a little investment, you can make more money using the broker's finances. For example, if you get a leverage of 400:1, you can double your account with just a 0.25% movement. For every $1000 that is in your account, you can trade as much as $400,000.
Are there any disadvantages of using leverage?
After what we have already gone through, I know you are thinking of the high chances of making some tidy profits by using leverage. Take note that it can also work against you. Just like it is possible to make money by using leverage, it is also possible to lose the entire account in one bad day. Just like you are able to double the account with a 0.25% movement in your direction, it is also possible to lose a whole account with a 0.25% movement in the opposite direction. Most traders tend to forget this when they overuse leverage.
How can you use leverage to your benefit?
That's a good question! You should realize that the more the leverage you use the more rewards and risks you are likely to be faced with. In order to avoid making high losses, it is important to use a 'Stop Loss'. Even as you think of the possibility of getting some high gains, it is important to keep your emotions in check. Agree with your broker on leverage that you wouldn't mind losing in one trade.
If you would like to have the optimum gain with a low loss probability, you should use a low leverage. Even with a leverage of 20:1 or 10: 1, you can still earn adequate profit and while keeping your capital reserve.
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