One of the biggest attractions of trading forex compared to other instruments is that you can leverage your trades. This allows you to make a lot of money from a relatively small stake. On the downside, it also means losses can be far higher than they otherwise would be. Since leverage can be a confusing concept for many inexperienced forex traders, let’s take a closer look.
How does Leverage Work?
Leverage increases the returns on an investment. Forex brokers offer leverage between 50:1 and 200:1. So, if your broker is offering you a 100:1 leverage ratio on a trade, you only need to deposit 1% of the total value of your trade in a trading account. You can trade $100,000 of currency with a relatively small $1,000 stake. This makes large – and potentially profitable – trades more accessible to amateur forex traders.
Why Do Brokers Offer Leverage?
Whilst leverage trading can maximize your losses by a huge margin, in reality, currencies rarely move more than 1% in either direction in a single day. The foreign currency market is volatile, but prices don’t fluctuate as much as, say, equities. If they did, brokers would be far more cautious and online traders would not have access to as much leverage.
When to Use Leverage
For obvious reasons, leverage should only be used when you are confident a currency is moving in the right direction. To use leverage when trading forex, open a margin account with a forex broker. Most brokers offer leverage of 50:1, 100:1, or 200:1. The leverage offered to you will depend on the size of the trade. If you open a position of 100,000 units of currency, you will most likely be offered 100:1 or 50:1. When trading 50,000 units of currency or less, it is customary to work with a 200:1 leverage.
How to Avoid Catastrophic Losses
In most instances, the risk of losing a lot of money is relatively low. Currency prices rarely move very far and sensible traders use stop losses to control their losses.
Forex trading is a game of odds. Always calculate your potential loss before using leverage. Experienced traders make sure their losses will not be any more than 3% of their trading capital. Calculate how much each pip is worth if a currency moves against you. If a loss represents more than 3% of your trading capital, the risk is too great.
This is where stop losses come in handy. Use stop losses to minimize your losses, even if you could make more money from your trades.
It is very important that you adopt a strict trading strategy when using leverage to maximize your trading profits. If a currency pair moves against you, leverage greatly amplifies your exposure to loss. Leverage is nothing to be afraid of as long as you manage the risk carefully. Customize your leverage to suit your needs and use smaller amounts of real leverage to give your trades more breathing room.