Leverage is one of the most influential tools traders use to generate more profits. However, it also comes with risks. It's essential that traders, especially beginners, understand how leverage works in trading, gain profit and avoid losses.
This article will discuss everything about leverage, its relation to the Forex market, and its benefits.
What Is Leverage and How Does It Work?
Leverage is a notional loan. It's using borrowed funds to invest in a currency to increase a trader's positions beyond what their available cash balance is capable of. It's notional in the sense that you don't physically receive the funds since they're automatically added to your trading account. With leverage, a trader can control more prominent trading positions even with small personal funds.
Generally, any trader can use leverage in various markets in the trading industry. You can use it on the crypto, index, and Forex markets. Moreover, several leveraged trading procedures use derivative products like spread betting and contract for difference (CFD).
Leverage and the Forex Market
Leverage in Forex is usually offered by and borrowed from brokers. Since Forex trading also depends on the exchange rate movements, whether following the trader's favor or not, many traders use leverage.
Many Forex traders use leverage to enhance their potential profits. However, leverage can come with a margin - a form of security for brokers. This is why it is often referred to as margin trading.
Margin-Based Leverage
Based on the margin requirements, the amount of leverage you can use for trading can vary. The leverage ratio represents this relationship between the two. A leverage ratio simply shows how leverage can possibly boost a trade based on the margin held by your broker.
For example, an investor buys a pair of EUR/USD for $100,000, and the broker requires a 0.50% margin. The $500 will be the margin to be held in their account. From this, the leverage ratio would be 200:1. With leverage, buying $100,000 worth is possible even with only $500 in actual funds.
To compute a leverage ratio, divide the total value of your transaction by the amount of margin required by the broker. The lower the margin requirement, the higher the amount of leverage used for each trade. However, remember that the margin requirement varies depending on the broker and the currency pair.
Advantages and Disadvantages of Leverage
Leverage is like a double-edged sword - it can be both beneficial and destructive. For a better perspective about how leverage can impact your Forex trading experience, here are the benefits and drawbacks of leverage.
Advantages
● It can increase potential profits. This is the most prominent benefit of leverage since it's generally used to ensure that your profit will grow from your transactions.
● It provides more trading and investing opportunities. With leverage, you can commit some of your funds to other investments.
● It improves capital efficiency since it increases profits and returns in a shorter period.
● It provides traders more financial capabilities to trade. It makes buying a considerable amount of pairs possible with a small actual fund.
Disadvantages
● It's a constant liability that you need to be responsible for. Because it's considered a loan, it requires payment.
● There's always a risk for a margin call that can incur significant losses since your positions can get liquidated or forcibly closed. A margin call can only be solved by adding more funds or closing some positions to lessen your exposure.
● It can lead to more losses instead of profits in the long run. Using a significant amount of funds also means exposing yourself to the possibility of a substantial amount of losses.
● You need to pay specific fees, like interests, and it will depend on how much leverage you received. Before you enter into a leverage deal, know and understand the conditions.
How to Manage Leverage and Its Risks
As you just learned, although leverage has excellent advantages, it also comes with risks. Managing these risks will help the trader be more at ease with enjoying the opportunities leverage offers.
Here are some tips you can follow for leverage and risk management:
● Don't trade with all of your available balance. Divide your funds and know where you should and should not use them. Exhausting everything in your bank account means risking everything you have.
● Use trailing stops. Setting up a stop to your positions can prevent you from incurring losses when the price moves against your favor. Similarly, when your position starts to gain profit, setting a limit will help you keep the profit instead of being surprised by a sudden drop in prices.
● Limit the amount of capital you put in for every position.
● Monitor your positions and transactions frequently.
● Avoid keeping large positions and keep them small as often as possible.
Conclusion
Leverage is beneficial when it comes to Forex trading. However, it's best to remember that there are also risks that come with it. You must understand how leverage works and how to manage the potential risks that you may encounter. Hopefully, this article gave you a good introduction to start using leverage properly.
