Forex Trading: Leverage

Forex Trading: Leverage

In the world of Forex Trading, many of us are exposed to the term “Leverage”. While we may have a basic understanding of leverage, many of us do not understand how it works, nor the intricacies behind it. Leverage is indeed a powerful tool that can amplify your profits, but it is important to also remember that leverage amplifies your losses as well. It is important to know more about leverage so that we are able to profit more effectively from the forex market. In this blog post, we will be discussing more about Leverage Trading in Forex.

What is Leverage?

In essence, leverage in forex trading allows traders to control a larger position size with a smaller amount of capital. For example, a 1:100 leverage would mean that your 1 dollar can control a position size of 100 dollars in the forex market. This would also mean that a one cent profit would be a dollar profit, if your leverage is 1:100.This matters in Forex Trading. Depending on the currency pair that you are trading, price movements could be in fractions of a cent and that would mean that your profits are also fractions of a cent without leverage. With leverage, your profits are amplified, and your losses are also amplified by the same ratio.

What this means would be that you could be making larger profits / losses with not only a smaller capital, but also a smaller price movement. As of the date of this post, the largest known leverage ratio is 1:1000. This means that a $1 dollar price movement on the chart could net you 1000 times the profit depending on your position size!

The opposite is true as well. A $1 dollar price movement on the chart at a 1:1000 leverage could also mean that you are going to suffer a loss that is 1000 times more. It is thus very important for traders, especially traders to realize that depending on your risk appetite and your trading strategy, a high leverage may not always be a good thing.

What is in it for the brokers to offer this?

Nothing comes for free in this world. There must be some form of benefit for brokers for them to offer you leverage. After all, they are lending you money, so that you can possibly make bigger profits. It is thus important for us to know the reasons why brokers are offering us leverage, and what these reasons mean to us.

Firstly, even though brokers lend us the money to trade, they are protected by what is called margin. In most brokerages, depending on the leverage that you are trading, brokerages will lock away a sum of your capital in your trading account to cover their losses in the event you wipe out your account. Once the funds in your account dips below a certain percentage, the brokerage will close your position. As such, brokers do not lose out when they offer you more purchasing power in the form of leverage.

Secondly, brokers do earn money from your trades. Because you are able to enter larger lot sizes due to leverage, you will enter larger lot sizes. Depending on your leverage, the brokers would get a correlated amount from the spread. At the same time, certain brokerages charge their users a commission fee that is dependent on the position sizes that they are entering. Due to the fact that you are entering larger position sizes due to leverage, the brokers inevitably profit more. These are the ways that a broker can earn money, relative to the leverage that you are using. For traders that hold trades overnight, brokers can charge swap rates based on currency interest rates, and earn profits relative to your position size.

What do we have to take note of?

It is recommended not to be lured in by high leverage, without understand that leverage affects your losses as well. It is more important to choose a leverage after you have assessed the losses that you can potentially take, instead of the profits you could potentially make. You have to understand that your capital is the key to making money in forex trading, and without your capital, you are unable to make profits.

Certain unscrupulous brokers may change the spread that they offer you and thus earn more from you. You will need to do your due diligence what are trustable brokers, and what are competitive spread rates across the different brokerages so you are not prey to unscrupulous brokers. At the same time, high spread and high leverage is a lethal concoction that can lead to significant losses. Any losses could be magnified and thus result in your account losing all its capital. Do your due diligence so that you are not in this position.

In Conclusion, leverage is an important concept to understand in Forex Trading. It is important that you understand how leverage works, so that you can choose the most suitable leverage for yourself. It is also important to understand the reasons why brokers are able to afford it, and it is most certainly not because of the kindness of their hearts that they offer you multiplicative purchasing power. Having the knowledge of all of this puts you in a better position to assess your own financial situation, and to do your due diligence to choose the right broker, as well as the right leverage to profit from the Forex Market.