What is leverage in Forex?
- What is Leverage in Forex
- How can a Trader use Leverage in Forex?
- How to manage risk according to Leverage in Forex
- Leverage as a weapon
Leverage has got several meanings and users. In fact, Leverage is used by investors to significantly increase the returns of their investments by even 400:1 the account value. They can lever investments made with different financial instruments, according to the Leverage allowed by the Broker. Leverage is even used by companies that can use it to finance their assets. In other words, instead of issuing stock to raise capital, companies can use debt financing to invest in business operations in an attempt to increase shareholder value.
Traders use leverage in Forex to profit from the fluctuations in exchange rates. The leverage that is achievable in the Forex market is one of the highest compared with other financial instruments like stocks. Leverage is possible thanks to a loan that is provided to a trader by the Broker that is handling the trader’s forex account.
When a trader decides to trade in the forex market, he or she must first open a margin account with a Forex Broker. Usually, the amount of leverage provided is either 50:1, 100:1, 200:1 or even 400:1, depending on the Broker and the size of the position that the investor is trading. We have to say that USA after 2008 financial crisis imposed a maximum 50:1 Leverage, in order to reduce risk for Traders. What does 50:1 mean? Leverage ratio means that the minimum margin requirement for the trader is 1/50 = 2%. That means a 50 times bigger risk for traders, but 50 times the value of capital gain. A Trader with a 10,000$ balance has got a “trading power” equal to 500,000$, because he just needs the 2% of margin of what he is going to invest. A 100:1 ratio means that the trader is required to have at least 1/100 = 1% of the total value of trade available as cash in the trading account (by supposing the 10,000$ of the previous example, a Trader could by until 1,000,000$ of EURUSD with a 1:100 Leverage), and so on.
We discussed what Leverage is and its role in trading. Traders can use Leverage to empower their account in order to trade with more money than they have. The higher the chance to gain, the higher the one to lose. Despite a trader can use Leverage and trade with more money, all the losses are charged on the account balance. In case of a 2% loss with a 1:50 leverage and a trade of 500,000$ (all the 10,000$ of balance are invested in this hypothetical trade), the whole 10,000$ are burned and the account gets closed. That’s an example of the riskiness linked to Leverage.
Leverage can be a good way to earn more money if the Trader is able to manage risk. Personally, me and my trading team decided some strict rules about leveraging. We are currently trading with a 1:400 Leverage account, but we do not go behind 1:3 Leverage for each trade we do. We exceed only for some well-defined cases, but the combination of Stop Loss and Leverage leads always to a 1.5% maximum loss per trade. That’s mean that if the trade is opened with a 1:10 Leverage for example, our stop loss is set to 0.15%, in order to lose no more than 1.5%.
That is just an example of the importance of money management while trading with a Leveraged account. We are still rolling the dice since almost 5 years of activity in financial leveraged markets thanks to these strict rules.
Leverage is a powerful weapon for traders with little capital, but it can be a backfire for those who do not know how to deal with it correctly. It is important to know what Leverage is and how to trade markets taking into account that risk increases while trading with Leveraged accounts. It is really important to always know the worst-case scenario for each trade and be sure that one loss do not compromise the amount stability. Once again, money management is the only important thing in trading, especially when trading with a Leveraged account.