Compared to other investment instruments, forex trading presents an attractive opportunity for many. One of the explanations for increasing attention to forex is the high leverage provided by most forex brokers. While experienced traders are aware of ups and downs of leverage, beginners often skip the basics and jump into live trading without a full grasp of what leverage is, how it works and how it impacts the risks and profits. So, first things first – let’s clear up some facts!
- Leverage is the use of borrowed funds to increase one’s trading position beyond what would be available from their cash balance alone.
- Brokerage accounts allow the use of leverage through margin trading, where the broker provides the borrowed funds.
- Forex traders often use leverage to profit from relatively small price changes in currency pairs.
- Leverage, however, can amplify both profits as well as losses.
What is Leverage?
Using forex leverage literally means borrowing money from your broker in order to be able to invest in trades. High leverage is offered because of the initial margin requirement. With leverage, your capital becomes 100 or more times larger and allows you to control and trade massive amount of money without actually having it!
How Much Leverage Can You Get?
Trading forex gives you a flexibility to choose leverage based on your financial status, trading strategies, risk management plan and personality.
In order to turn the minute price movements into decent profits, traders need to use leverage. The leverage varies from 50:1, 100:1 and 200:1. However some brokers dare to offer even larger leverage.
Let’s consider an example:
With a deposit of $1,000 and leverage of 100:1 a trader is actually able to control the amount of $100,000. When you control large amount of money, small fluctuations in price of the currency may either bring amazing profits or devastating losses.
What is the Risk Involved?
Forex leverage can significantly enlarge your profits. At the same time, it can also expand your losses. The more leverage you apply on the money you actually have in the trading account, the higher risk is automatically attached to every trading decision you make.
Too Much is Never Good
It is crucial to stay away from greed at all cost and never trade amounts you cannot financially handle. Smaller leverage gives you a reasonable flexibility and a chance for wider stop/loss, therefore protecting you from risking to much of your trading cash.
High leverage can literally eat up your account within minutes, in case the trades go against your decisions. Be reasonable with your leverage selection and weigh the risks involved.
Google true stories on leverage use, and you will find the net full of disaster stories related to high leverage. It shows that excessive leverage almost always leads to excessive losses.
Not convinced yet? Consider the economic disaster that is still affecting the whole world. Investment banks were trading 40:1 leverage in some cases. The banking crises in US was caused by banks not buying based on solid fundamentals but rather using disproportional leverage to buy securities.
Risks of leverage in FX trading
As much as leverage trading can be seen as a way to increase your forex profits, it also magnifies your risks. For that reason, having an effective risk-management strategy in place is essential for using leverage in forex. High leverage forex brokers usually provide key risk management tools, including the following list, which can help traders to manage their risk more effectively.
A stop-loss order aims to limit your losses in an unfavourable market by closing you out of a trade that moves against you at a price that is specified by the trader. You are essentially specifying the amount you are willing to risk on the trade. However, even if a stop-loss is in place, the close out price cannot be guaranteed due to slippage.
A trailing stop-loss works similarly to a regular stop-loss. However, when the market moves in your favour, the trailing stop-loss moves with it, aiming to secure any favourable movement in price.
A guaranteed stop-loss order (GSLO) will be executed at the exact price you want, regardless of market volatility or gapping. For this benefit, there is a premium payable on execution of your order, which is displayed on the order ticket. The premium is refunded if the GSLO is not triggered.
A take-profit order works in the same way as a limit order as it is always executed at the target price you specify. Where the market for any product opens at a more favourable price than your target price, your order will be executed at the better level, passing on any positive slippage.
How to manage risk
As discussed throughout the whole article, leverage involves the risk of losses exceeding your expectations. However, there are various risk-management techniques that can be used to limit potential losses.
A stop-loss order aims at limiting losses in a market that is not so favourable, by making you exit a trade that moves against you based on the predetermined price. What happens with stop-loss orders is that you basically determine the amount you can afford to risk. Nevertheless, keep in mind that since markets move too fast, there might be specific conditions that may not trigger your stop-loss order at the set price.
For the reasons outlined above, new traders should maybe start with leverage once they feel familiar using it and first practise using a demo account.
Frequently Asked Questions About Best Forex Leverage for Beginners
- Is it necessary to use leverage when trading? It is not necessarily that you use leverage. You can use your funds to open trading positions and still earn money. Alternatively, you can trade for prop firms like Audacity Capital and have your account funded.
- Does leverage allow traders to earn more profit? Yes, leverage improves account efficiency, allowing you to make a good profit in the shortest time.
- How can I avoid losing money while using leverage? The only way to avoid losing your deposit is to use risk management skills while using leverage.
- Are there any disadvantages of leverage? Leverage is a very complex financial tool and should be respected as such. While it sounds fantastic in theory, the reality can be quite different once traders come to realize that leverage doesn’t only magnify gains, but it also magnifies losses. Any trade using leverage that moves against the trader is going to create a loss that is much larger than it would have been without the use of leverage. This is why caution is recommended until more experience with leverage is gained. This can lead to a longer and more prosperous trading career.
Forex trading success relies on slow and calculative decisions, rather than random guesses and hopes for millions by the end of this month.