Understanding how to trade forex isn’t always the easiest of tasks, as 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, as through correct use, it 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 to get a grasp on what leverage is appropriate for your forex trading strategy and all-round 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 that can be generated on a trade. The forex market traditionally offers one of the highest levels of leverage amongst all forms of investing. What this means is that with a high leverage level that’s 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
If it isn’t already obvious, leverage has played a key role in the expansion of forex trading within the world of investing. More investors than ever are now looking towards 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. Looking at an example, 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, should you have $10,000 in your account and you choose to open a $100,000 position, by default, you are trading with 10x leverage. Now, should you trade two standard lots ($200,000) instead of a single standard lot ($100,000), you will then be trading at 20x leverage. You can probably start to figure out how this works from a real leverage perspective using these examples, with the leverage offered being related to the level of margin and the discretion of the broker.
Understanding Associated Levels of Risk
As you can plainly see, by making use of leverage, you can magnify not only your profits but, should things take a turn for the worse, your losses as well. Think about it this way: The greater the level of leverage you use, the greater the level of risk you take on. What this means is that leverage can often represent a double-edged sword, as a market shift could harm not just a single position but also your entire portfolio. At minimum, 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 invoke a system that sees positions automatically close out when the margin within a trading account has been depleted due to adverse market movements.
There is no denying that the correct use of leverage can turn a potentially small profit into something much larger. However, what it does require a trader to do is take on increased risk exposure; thus, monitoring account activity becomes all the more crucial. When you are looking towards using leverage, what amount is suitable for your current situation will largely come down to available margin and the level of acceptable risk.
Understanding what level of leverage is best for your forex trading efforts isn’t all that complicated, with the final call largely being 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; this is 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.