Using Leverage When Trading on the Foreign Exchange Market
There are a lot of traders who make their profits from the use of leverage on the foreign exchange. It is important that you understand what leverage is and how you can use it on the foreign exchange. Of course, you also have to know about the risks related to this.
What is Foreign Exchange Leverage?
Leverage is the borrowing of money to use in an investment. In the forex market the money is borrowed from the broker to purchase larger lots. Forex broker offer high leverage is the sense that you can control large amounts of money with a minimal initial margin. It is possible to calculate the leverage amount needed to complete a trade. To do this you need to divide the value of the transaction by the margin you have to put up.
The margin-based leverage is not actually what affects the overall risks of trading. What you have to look at is the real leverage amounts you will be using. To calculate real leverage you divide the value of the transaction by the capital in your trading account. As traders never leverage their entire trading account on a single trade the real leverage amount will be different to the margin-based leverage.
Excessive Leverage Use Risks
While real leverage has the potential of making you a lot of money it can also cause you to lose a lot of money. The higher the amount of leverage you use the greater the risks involved. When you apply leverage you should always keep the rules of successful trading in mind. The most important rule to remember is to never risk more than 5% of your account capital on a single trade. You have to calculate whether the leverage you use will risk more than this percentage.
The easiest way to see how leverage can cost you money is to look at an example. Two traders each have $10,000 capital in their account and trader 1 is using 50 times real leverage while trader 2 is using 5 times. The value of the trade for trader 1 is $500,000 and for trader 2 is $50,000. If there is a 100 pip movement against the traders then trader 1 stands to lose $4150 which is over 40% of their account capital. However, trader 2 only stands to lose $415 which is 4% of their account.
It is very important that you calculate the amount you could lose. While trader 1 could have made $4150 they can lose that as well. As this amount is almost half their total trading account it is not recommended that they use the leverage they considered.
Using Leverage when Trading
When you trade forex you want to make the most out of your trading account capital. When trading, you are monitoring the pip movements of a currency pair, but these incremental movements are only fractions of a cent. With most trading pairs a movement of 100 pips is only worth 1 cent. This is not a very large profit and can be de-motivating for new traders.
With the use of leverage you can use relatively small amount of capital to purchase large amount of currency. It is only through these large scale transactions that the incremental movements of the market can turn into a decent profit. The amount of leverage you use should relate to your trading style and the risk management plan you have in place.