Leverage is a very frequently used term in the world of trading. You’ve probably heard it a lot among investors and brokers. You know it has something to do with investing and capital, but what’s leverage exactly? It sounds like a very overwhelming word but in its simplest form, it just means using borrowed capital to invest.
In forex trading, the use of leverage is quite prevalent. Investors borrow funds from high leverage forex brokers and use these to open higher trade positions in their chosen currency. Leverage boosts the profits that investors gain from a profitable trade. However, this same leverage also increases the losses in case the currency value drops.
When used wisely, leverage can be a powerful tool in forex trading. However, online trading will always have its risks. It is therefore crucial for a forex trader to fully understand how leverage works before making any transaction. It is also necessary to enforce a few cautionary measures to control potential losses.
How to Use Leveraged Products in the Forex Market
Forex trading means buying or selling a currency to make a profit sometime in the future. For example, you decide to buy an amount of GBP/USD now because you believe that the value will increase. After a few hours, your prediction comes true and the value increases. You then sell the amount that you bought earlier, now at the increased price, which means you earn a profit.
With the help of leveraged products, you can magnify your profit multiple times. Say you want to buy $10000 worth of GBP/USD. You don’t have to pay $10000 but only a small percentage of this amount. The broker will let you know the exact percentage. Typically, this will be around 2-3%. This will depend on the currency pair and a few other factors, like the size of the trade. This amount that you pay is called the initial margin.
Before you can trade using margin, you first have to set up a forex account. This is where you are going to deposit funds that you can use to spend on margin. If you are a new online trader, your broker may set more stringent limits on the leverage you can use. As you get established in online trading, you will be able to customize the trade size depending on the leverage you prefer.
Understanding Leverage Ratio
The leverage ratio is the ratio of how much money you invest to the amount that the broker is letting you borrow. Leverage is a common tool used in practically all trading environments. In forex trading, however, the leverage ratio is usually much higher, making it a more attractive option for investors.
If your broker offers you a leverage ratio of 1:300, it means you can control a leveraged position of $300,000 with an initial margin of only $1,000. Thus, your potential profit will increase by 300 times. Such a big number can make you giddy but be careful. Remember that trading is a risk and the outcome can go either way. In case of a drop in value, your losses can also increase by as much as 300 times.
Factors That Determine Leverage Ratio
Margin Requirement
The margin requirement determines the leverage ratio. A typical margin requirement of 2% is equivalent to a leverage ratio of 50:1. If the margin requirement is 1%, the leverage ratio is 100:1. As the margin requirement gets smaller, the leverage you can have on your forex trade gets bigger.
When trading major currency pairs that include the US dollar, the margin required is usually smaller and thus the leverage ratio is bigger. When trading other major currencies that do not involve the USD, the price movements are more volatile. For this reason, brokers require a higher margin so the leverage ratio is usually smaller.
Trade Size
The trade size is also another factor that affects the leverage ratio. Higher trade positions of major currency pairs usually get standard leverage of 100:1 or 50:1. For smaller positions of say, $50,000 or below, brokers are willing to offer higher leverage of 200:1.
For emerging currency pairs that have higher volatility, brokers will ask for a higher margin of up to 20%, regardless of trade size. This equates to a lower leverage ratio of about 20:1 or even lower at times.
Dangers of Using Leverage in Forex Trading
The attraction of leverage in forex trading lies in the ability to control huge amounts of investment with just a small deposit. But as the saying goes, leverage is a double-edged sword. With this exciting benefit comes corresponding risks.
First of all, the potential losses are just as huge as the potential gains. Also, if you don’t maintain proper margin management strategies, you can easily end up with zero equity in your forex account. Remember that you should always have sufficient funds in your account to cover possible losses. In case you don’t have enough, you will get a margin call, which will require you to come up with more funds.
Margin management also includes practicing caution in making transactions. Opening multiple leveraged positions is very tempting because of the low initial margin requirement. This can have a lot of benefits if you have exceptionally good financial instincts. But if a disaster occurs and your positions all drop, it will spell huge trouble.
How to Protect Your Investments from Leverage Risks
A practical way that online traders use to minimize losses is the use of stop-loss orders. This is a predetermined agreement that you have with your broker where you instruct them to automatically close any of your trade positions when a specific price is reached. In case of a decline, you will still take a few hits but it will not be an insurmountable disaster.
It is also a good idea to stay with lower leverage so you can have a broader stop range, especially in the more volatile currency trades. This strategy can reduce your potential earnings but it will also surely reduce your possible losses.
