It is normal for a beginner forex trader to be asking questions like “what is leverage in forex?” and “how is it trading forex with leverage?”
To my surprise, there are forex traders out there that are actively trading, yet they do not know what forex leverage is all about.
What is more surprising is that they actually choose their preferred leverage option while activating live accounts. It sounds ridiculous, isn’t it?
I have written this article to try and shed some light on what is leverage forex.
What is Forex Leverage?
Leverage means having the ability to control something big using something small (to use a layman’s terms).
In forex trading, leverage means having control over a huge amount in the market while having a small amount of trading capital in your account.
For stock traders, this is trading on margin.
No interest is charged on the margin used in forex trading regardless of the type of trader you are or the kind of credit you have. If you have an account and the forex broker offers margin, you can freely trade on it.
The advantage of using forex leverage is that you could make a lot of money from a small capital. The disadvantage is that you can experience an enormous loss when you trade with leverage.
It’s like the two sides of a coin or a double edge sword.
Winning or losing in forex trading depends on how smart you trade, your risk management abilities, and how good your forex psychology is.
Using Leverage in FX
When leveraging in Forex, traders make use of leverage to make profits from fluctuations in foreign exchange rates.
The achievable leverage in forex trading is the highest one that traders can obtain. To activate leverage, one requires a loan that a trader attains from a broker that is handling the trader’s forex account.
A trader ought to first open a margin account with a broker before they begin trading in the forex market.
The amount of leverage that is normally offered is either 1:50, 1:100, or 1:200, depending on the account broker and the investor’s trading position size.
There are forex brokers that even given leverage to the tune of 1:500 and 1:1,000.
This means that a 1:50 leverage ratio offers the trader the minimum margin requirement at 1/50 = 2%.
With a 1:100 ratio, a trader should have at least 1/100 = 1% of the total worth of trade available in the form of cash in the trader’s trading account and so on for the other ratios.
Average forex trading is done on 100,000 units or 1 standard lot(Check this post on What is a Forex Lot Size ) of currency, and therefore for a trade of such size, the leverage offered is normally 1:50 or 1:100. 1:200 leverage is normally offered for $50,000 or less positions.
So as to trade $100, 000 of currency with a 1% margin, a trader is only required to deposit $1000 into their account.
The leverage provided on such a trade is 1:100.
This size of trade has a larger leverage than the 1:2 leverage mainly provided on equities and the 1:15 leverage offered in the futures market.
As much as 1:100 leverage may look so risky, the risk is considerably less, considering that currency prices do change by less than 1% during trading within a single day.
If currencies could fluctuate like equities, brokers would not manage to offer as much leverage.
Which is the Best Leverage in Forex Trading?
As beginner forex traders are asking what is leverage in forex, those that have been in the market are asking on the best level of forex leverage to use.
This is one of those questions that I normally say the answer is not black and white.
I see most forex “gurus” out there advising that 200:1 and 100:1 is the best forex leverage to use.
How do they arrive at this conclusion?
To me, I think the appropriate leverage for a trader to use varies based on several factors like the markets being traded, account size, and general experience in forex trading.
There are markets that would require a bigger margin compared to others. Something like trading gold would require a bigger margin compared to trading the other currencies.
Someone that is trading gold solely and has a small account would require higher leverage as a result.
When it comes to the account size, a forex trader with a big account does not need to use big leverage since they can manage to cover the margin required to leave several trades open.
With trading experience, this is where I get more interested in the issue of trading forex with leverage.
Forex leverage might be enticing to most beginner forex traders; furthermore, it is like having more money to trade hence having sufficient margin to take the trades that you want.
As a newbie trader, please don’t be tempted by this aspect. I would recommend that you go for the lowest leverage or go with none at all.
This is because forex leverage will be the beginning of you burning your trading accounts if you do not know what you are doing.
I would advise that you begin without leverage and incorporate it as you gain experience little by little. This will help you to avoid overtrading and entering into unwanted trades.
What are the Benefits of Trading Forex with Leverage?
The most important benefit of forex trading on leverage is that you earn more money through less effort and capital.
It does not matter what instrument you are trading, even when you input little or more capital, leverage helps you to increase your profit from any transaction by multiplying the stakes.
More profit could be attained by investing more capital in every position, but leverage works to ascertain it’s always a step ahead in artificially increasing your available capital in multiples of even hundreds.
No matter the particulars and the clear points of why leverage is important in forex, no one should tell you that leverage in forex plays a different role for them.
Leverage is mainly about making more money from the same trades by basically raising the stakes without tying up more of your capital.
Low Volatility Mitigation
Forex leverage also helps to mitigate against low volatility. Volatile or rather unstable trades are those that deliver good profit because the markets move in wider cycles on long trends compared to stable trades.
In the forex market, mainly due to the cautious nature of the parties trading currency and the small range of factors which can externally show currency price changes, volatility mainly appears towards the lowest end of the scale.
At this point, leverage comes in to help deliver larger profits from smaller position sizes.
In as much as Leverage has the effect of mitigating against low vitality, it can also turn against your position and cause you great losses instead.
Increase Capital Efficiency
When you increase the amount of money you can earn in each trade, you automatically increase the efficiency of your capital.
Consider your capital as an asset with the ability to grow, for instance. If it takes you two days to attain £100 without leverage positions, leveraging will shorten the period of time you use to earn the same £100. It will also reduce the number of trades that you need to take.
This means you can re-invest your capital over and over to get the most frequent and substantial yield it possibly can attain.
With capital efficiency, trading forex with leverage makes a great impact and not only ensures greater profits within a short time but also considerable returns on investment in a short time.
By now, I hope you are not still asking what is leverage in forex trading?
Can Forex Leverage Backfire on You?
That is a very big YES.
Trading forex with leverage enables traders to earn the most from their invested capital but could also work against them. For instance, if the currency underlying one of your trades changes contrary to what you believed would happen, leverage would largely increase the potential losses.
That is why you have to be cautious with leverage in trading since it is a double edge sword. It can work for you or work against you.
As a result, focus more on being a good trader first before you start debating on the level of leverage that you should be using.
How to Manage Forex Leverage Risk
Given that trading forex with leverage can give good as well as undesirable outcomes for forex traders, it is therefore important to identify the appropriate leverage level for your trading and properly incorporate sound risk management.
Profitable traders take advantage of stop-loss to control their downside risk in forex and also make use of a positive risk-to-reward ratio to achieve higher probability trades with time.
As you start, make sure that any trade you take has at least a risk to reward ratio of 1:1. As you develop your trading skills and entry timings, you can now aim for a risk to reward ratio of at least 1:2.
As you begin forex trading, I would recommend risking no more than 1% of the account capital on one trade and no more than 5% of the account capital for every open trade at any given time.
I hope now you know what is leverage in forex trading and how to use it.