Understanding how to trade forex isn’t always the easiest of tasks. In order to successfully turn a profit, a trader must have detailed knowledge of the market, the right trading strategy, and a selection of functional trading tools. One tool that is commonly praised is leverage. Through correct use, leverage can boost a trader’s output without the need for any additional capital up front. This article takes an in-depth look at leverage, helping you grasp what kind of leverage is appropriate for your forex trading strategy and overall market approach.
What is Leverage?
Before we delve into the pros and cons of using leverage, it is worth addressing exactly what leverage is. Leverage is a service offered to investors by many forex brokers that allows them to increase the returns generated on a trade. The forex market traditionally offers one of the highest levels of leverage among all forms of investing. With a high leverage level based on an average initial margin requirement, an investor can amass and control a large amount of trading capital. Usually, leverage amounts vary upon margin, coming in forms such as 50:1, 100:1, 200:1, and 500:1.
Explaining the Types of Leverage
Leverage has played a key role in the expansion of forex trading within the world of investing. More investors than ever are now looking toward the market as a means to make their capital go further. However, when looking at the forex market, there is no one-size-fits-all leverage option at hand. To truly understand leverage and its potential impact, you need to look at two factors in particular: margin-based leverage and real leverage.
Margin-based leverage can be calculated by dividing the total transaction amount by the level of margin you are required to make available. Let’s say you are trading USD/JPY to a standard lot size of $100,000. You would need to deposit the equivalent of 1 percent of the total cost as the margin. The margin in this instance would be $1,000, with margin-based leverage equalling 100:1 (100,000/1,000).
In order to understand the real degree of leverage within any position you are undertaking, you must divide the total value of your positions by your trading capital. For example, if you have $10,000 in your account and you choose to open a $100,000 position, you are trading with 10x leverage. If you trade two standard lots ($200,000) instead of a single standard lot ($100,000), you are trading at 20x leverage. The leverage offered is related to the level of margin and the discretion of the broker.
The Most Popular Leverage Trading Strategies
Leverage trading can be implemented into pretty much every pre-established forex trading strategy. However, it is more effective when used in conjunction with certain trading strategies. When short-term trading is the objective, you’ll find that leverage can be a pretty potent trading tool. The following two trading strategies aren’t only popular, but they also implement leverage effectively.
Scalping is an incredibly popular forex trading strategy and can be combined with a high leverage approach to the market. Those choosing to scalp often do so with extreme leverage amounts, anywhere between 1:1000 and 1:3000 being common, opening low spread trades on pairs, setting small pip targets as a means to compensate for the high exposure level. Risk control also proves to be pretty stringent, with tight-take profits and stop losses in effect.
The advantage scalping typically has over other trading methods is speed: A scalp trader can wrap up positions in minutes, if not seconds. This allows a trader to move quickly, placing more trades and investing more capital during a trading window. Due to the leverage implications, it isn’t unheard of for a trader to earn 15 to 20 percent of his or her equity in one day, if they are willing to embrace the extreme risk exposure.
When day trading, you are working on a time limit every time you log in to your preferred trading station. This puts increased pressure on the need to open and close positions, with a notable daily profit being a challenge to obtain. Leverage trading when day trading can help any trader make profits faster and/or in larger quantities. When the right amount of leverage is used, it can work wonders in increasing your day trading buying power.
Day trading with leverage carries risk, but the nature of day trading almost makes leverage a necessity, allowing you to maximise your trading capital and effectively giving you a leg up as you open and close positions throughout the day. Using leverage responsibly, you can take your trading efforts to the next level.
Advantages of Leverage Trading
Forex trading with leverage allows any trader to boost trade sizes without an increase in capital. This is the major advantage of leverage trading, and it provides a leg up for those that aren’t blessed with an endless stream of funds. The average starting balance for a forex trader is somewhere in the low four-figure range, but even that figure will prove to be out of reach for some, while low-level leverage at 1:10 allows someone with just $100 to enter a 0.01 lot position.
Understanding Associated Levels of Risk
By making use of leverage, you multiply not only your profits but your losses as well, if things turn for the worse. Think about it this way: The greater the amount of leverage you use, the greater the risk you take on. What this means is that leverage acts as a double-edged sword, because a market shift could harm your entire portfolio. Anyone who chooses to engage in leverage needs to keep a close eye on his or her margin requirements for open forex positions, because a large number of forex brokers use a system that sees positions automatically close out when the margin within a trading account has been depleted by adverse market movements.
There is no denying that the correct use of leverage can turn a potentially small profit into something much larger, but it requires a trader to take on increased risk. Thus, monitoring account activity becomes even more crucial. When you are considering using leverage, what amount is suitable for your current situation will largely come down to available margin and the level of acceptable risk.
Before You Use Leverage
Before opting to use leverage, here is an example of how a less than positive leverage situation could pan out: A trader has acquired $1,000 for £800; following this, the price of the USD plummets by 50%. Had the trader not been invested in a leverage-based trade, he or she would strictly lose half of the funds, equating to £400. Weigh the same scenario with a leverage of 1:100 in effect and the picture becomes much bleaker, as the trader would lose all of his or her funds.
Depending on how you wish to trade, a number of leverage options could be available, but as shown by the example above, leverage is not a carefree way of increasing trade size. You should always be prepared for the risks associated with leverage-based trading, and understand its potential impact. We advise practicing both leverage and unleveraged trades within a demo account to gain a firm grasp on whether or not leverage suits your trading approach.
What Happens if You Don’t Use Leverage?
Trading without leverage is always an option, but for those with true forex trading aspirations, it will present its own issues. First, the starting capital required to trade with the best of intentions is simply not accessible for most traders. When leverage isn’t used, the price of a currency pair is going to have a direct impact on your bottom line. Figures show that the average monthly return of a moderately successful trader is approximately 10 percent, but for those with lesser capital and trading experience that figure falls to between 3 and 5 percent. This figure accounts for marginal trading, which drives profits down further, potentially as low as 0.5 percent. For some, this figure might be enough, but for anyone with true forex trading ambition, it won’t be.
When you trade without leverage, the lack of capital can quickly become an issue, even if this means that there is less risk exposure. Here’s an example that should further help you understand no leverage trading: You deposit $10,000, generating a 5 percent monthly return, or $500 profit per month. Quite frankly, such a figure isn’t worth the effort, especially when you consider the time, capital, and effort required to actively trade forex. Through this example, you can start to see why trading with leverage is an option many traders explore.
Leverage can, without a doubt, be a risky venture, but the statistics speak volumes. For those with less than average trading capital, leverage presents the chance to increase profits without causing an immediate impact to your bottom line. Trading without leverage might be less risky, but it will likely hold you back from achieving your true forex trading goals.
Understanding what level of leverage is best for your forex trading efforts isn’t all that complicated. It’s largely linked to the level of risk you are willing to accept. The reality is that leverage trading may not be appropriate for everyone. For that reason, you should adequately test any trading plan you have, understanding how and where leverage can be factored into it. Do this before putting it into a live market environment and risking real capital.
The information provided herein is for general informational and educational purposes only. It is not intended and should not be construed to constitute advice. If such information is acted upon by you then this should be solely at your discretion and Valutrades will not be held accountable in any way.