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Forex Trading and Leverage: What You Need to Know

Forex Trading and leverage often go hand-in-hand, and one of Forex Trading's biggest drawcards is the ability for traders to use leverage. When using leverage, traders have the potential to amplify their trading returns significantly.

Forex trading and leverage

Introduction

Foreign Exchange Trading, or Forex Trading as it is commonly known, is extremely popular amongst traders looking to profit from the price movement of different currency pairs in the Forex Market.

Forex Trading and leverage often go hand-in-hand, and one of Forex Trading's biggest drawcards is the ability for traders to use leverage.

When using leverage, traders have the potential to amplify their trading returns significantly.

However, leverage is not without its risks. While also increasing the potential for profit, it puts the trader at greater risk if the trade goes against them.

Successful traders know how to use leverage to increase their profits, but also how to mitigate the downside risks.

Understanding the benefits and risks of leverage, as well as how to mitigate the downside risks is crucial to trading success.

What is Leverage in Forex Trading?

Leverage enables a trader to borrow additional money against their capital. The capital used as collateral to borrow money against is known as margin.

In other words, leverage allows a trader to control a larger position in a currency pair relative to the amount of their own capital invested.

Leverage is expressed in ratios such as 50:1, 100:1 or 400:1

The leverage ratio indicates how much capital the trader can control relative to their own money.

For example, a trader with $1000 of capital, using leverage of 100:1, will be able to control a $100,000 position.

Likewise, a trader with $1000 of capital using leverage of 50:1, will be able to control a $50,000 position.

The leverage used is typically provided by the broker.

Leverage in Forex vs No Leverage

Using leverage in Forex trading can dramatically increase your potential returns. This attracts many traders who can make a sizeable profit with a relatively small amount of capital.

Using 2 hypothetical examples of leverage in trading, we will illustrate this below.

Scenario with no leverage

You invest $1000 into a Forex Trade using no leverage

The position moves 1% in your favor

Your profit is $10 (1% of the $1000 investment)

Scenario with leverage

You invest $1000 into a Forex Trade using 100:1 leverage

The position moves 1% in your favor

Your profit is $1000 (1% of the $100,000 investment, which is the amount of money you can control)

Brokers will typically offer 3 different levels of leverage: low leverage, moderate leverage, and high leverage, which refers to the leverage ratio being used.

Low leverage:

Ratios of 5:1 and 10:1 are much lower risk yet also offer slightly amplified returns. Low leverage is more suitable for conservative traders, new traders, or those still refining their trading strategy.

Moderate leverage:

Ratios of 50:1 or 100:1 are considered moderate leverage. These offer a good balance between risk and reward and are commonly used by many retail traders.

High leverage:

Ratios of 200:1, 400:1, or even higher are very risky and can result in substantial losses very quickly. However, the potential payoff if a trade moves favorably will be very significant. Only experienced traders should consider using high leverage.

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2. Greater capital efficiency

Leverage enables Forex traders to use their capital much more efficiently.

If a trader only has $1000 of their own capital, they will not only be limited in their profit potential but also in how to allocate their capital.

Through the use of leverage, traders can use their capital more efficiently by controlling more money and hence being able to utilize their capital more efficiently.

3. Hedging and diversification

The ability to control more or larger positions means that traders can diversify their money better.

Furthermore, people who are overly exposed to a specific currency can use the Forex Market to hedge against risk.

Through the use of leverage, traders can offset current risk without needing a substantial capital outlay.

Forex trading and leverage

Risks of Using Leverage in Forex Trading

Of course, using leverage in Forex is not without its risks. Just as leverage can offer several benefits in the Forex Market, it also brings certain risks with it. We will look at 3 of the most common risks associated with Forex Trading.

1. Magnified losses

Just as leverage enables Forex Traders to amplify their returns, so does it increase the risk of substantial losses.

Relatively small moves can result in fairly significant losses, which is why risk management becomes even more crucial when leverage is being used.

2. Increased emotional pressures

A big part of successful trading is being able to manage your emotions and keep them in check.

The allure of massive gains and the fear of substantial losses can paralyze traders and make it more difficult to follow any pre-determined trading strategies.

Understanding leverage and margin

Although margin and leverage are closely related, they are not exactly the same.

While leverage is the amount of money that you can borrow to invest or trade, margin is the amount of money required to maintain in your account in order to keep a leveraged position open.

For example, if using a leveraged position of 100:1 with $1000 as collateral, a trader will be able to hold an open position of $100,000.

However, the margin required to maintain the open position of $100,000 is $1000 - this is called the margin requirement.

Therefore, the margin is the trader's actual money at risk.

If a trade moves against the trader, the losses will be deducted from the margin amount until the position is either closed or the trader funds their trading account with additional money.

How to Manage Leverage Risks in Forex Trading

When using leverage, understanding the associated risks is essential.

Using appropriate risk management strategies should be non-negotiable to avoid excessive losses. We will look at just 3 of the most common risk management strategies below.

1. Understand how leverage works

Leverage should never be used if it is not clearly understood.

Furthermore, it is best to start with low leverage, like 5:1 or 10:1, until you have built up enough confidence to increase your leverage ratio.

Be sure you understand how margin and leverage work together and use leverage ratios in line with your personal risk tolerance.

2. Monitor your margin levels

If a trade goes against you, be sure to keep an eye on the margin level in your account.

If your margin level drops too low, you will be in danger of a margin call.

This is when the broker alerts a trader to increase the available equity in their trading account to maintain their current positions.

The trader will be required to either close existing positions or add more funds.

3. Use stop-loss orders

This is a common tool traders use to 'limit' the losses.

A stop-loss order automatically closes an open position at a pre-determined price level.

Although this strategy essentially locks in a loss, it prevents the trade from continuing to go against the trader, resulting in further losses.

This is an effective way to preserve your capital and manage your emotions.

Conclusion

Although leverage can be an incredibly powerful and valuable tool, utilizing it correctly is vital to profitable trading.

Ensure you understand how leverage and margin work together, implement a clear trading plan and start with low leverage to begin with.

Furthermore, understand your own personal risk tolerance and ensure you would be able to manage a margin call should it happen.

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