What is Leverage in Forex trading

What is Leverage in Forex trading

Forex

It is an established fact that the goal of every trader is to make a profit at the end of the day. The forex traders are no different. The forex market offers traders many advantages to fulfill their deepest desire and that is to make a profit.

Some of the noteworthy advantages are the low costs on commissions. Imagine a forex world where traders pay 50% of their investment amount on every trade as commission. Or a world where traders pay 50% of their profit to traders as commission. What do you think will happen to the forex market? It will collapse. You guessed right. Because traders like you and me constitute the majority of participants on the forex market. But thank God that is not the case. The commission paid by traders to brokers is very small and insignificant.

Secondly, forex offers very high liquidity to traders compared to other markets. High liquidity means that large orders of currencies are traded efficiently without any significant price deviations. Forex traders don’t have to worry about extremely high volatility during the opening and closing hours of the market or stagnant price ranges which are the characteristic features of the equity market. Without any major events, similar price patterns can be observed.

Another advantage that forex traders derive is the fact that the forex market is decentralized.  This means there is no central exchange of currencies. The advantage this serves is that it prevents sudden surprises as compared to the equity market. With equity market, a company can suddenly declare huge losses which will affect prices.

Trading on the forex market allows diversity in trading styles. The market is opened for 24 hours a day due to different time zones which makes trading very convenient for forex traders. Especially short-term traders who prefer to take positions for only short time periods.

Another major advantage that forex traders have over their comrades in other market types is relatively higher leverage. There are many forex traders who are enjoying the advantages that leverage trading offers without fully understanding what it means. This stems from the fact that everybody likes free things and forex leverage in a way offers that. Because you will be trading with someone else’s money and keeping the profit you make to yourself.

What is forex Leverage?

Forex leverage involves borrowing money from a broker to increase your account flexibility and potential to make profit. So how does leverage work in forex? In simple terms, imagine you trade with $1000 of your own money on a currency and you make a profit of $500, trading with forex leverage will give you $3000 to trade with and by this logic, you will make 3 times the initial profit making $1500. Leverage offers a great advantage to traders because forex trading without leverage would be like the 21st century without electricity and would simply make forex trading unaffordable for the majority of participants.

What does leverage ratio mean in forex?

In most cases the amount of the leverage provided is displayed as ratio of borrowed capital to your actual capital. The ratio can be 50:1, 100:1, or 200:1 depending on the broker or the size of the position of the trader.  A leverage ratio of 100:1 means that a trader is required to have 1% of the total value of the trade in his trading account. It is important to note that most brokers require traders to have certain amounts in their accounts to meet the requirements for getting leverage.

How to calculate leverage in forex?

There are two variables in leverage calculation. The margin-based leverage and the real leverage. If you want to know your margin-based leverage, divide the value of the total transaction by the amount of margin you are required to give out.

Margin-based leverage =    Total value of transaction 

Margin required

For instance. If the total value of your transaction is $100,000 and you are required to deposit 1% of the total transaction, your margin would be $1,000. Therefore your margin-based leverage would be 100:1 which is represented below as stated by the formula above.

Margin-based leverage = $100000

$1000

To calculate the real margin, you divide the total value of the transaction over the total amount of money in your account.

Real margin = Total value of the transaction

Total trading capital

The introduction of leverage trading to traders has been of significant help. Traders use leverage to make huge sums of profit from little fluctuations in price movements of currencies. Generally speaking, it is not advisable to use all your available margin. You should use leverage only when the advantage is on your side. It is possible to determine the potential loss of capital once you know the amount of risk in terms of the number of pips. As a rule, the loss should not exceed 3% of your trading capital. If you leverage a position to a point that your potential loss could be 30% of your trading capital, you should reduce the leverage by this same measure.

How leverage can backfire.

Despite the fact that the use leverage increases the profit margin for a trader, it can also work the other way around by increasing the loss margin. For instance, if the currency took a position on moves in the opposite direction contrary to what you believed would have happened, the leverage would magnify the potential losses. To avoid these cataclysmic results, a trader needs to apply the stop orders and limit orders which have been purposely designed to limit losses.

Conclusion

In as much as it excites us when we make huge profits using forex leverage, we need to exercise some level of restraint. Because in the same fashion that leverage multiplies our profit, it also multiplies the loss. Take note that using leverage does not make your trades immune to risks on the forex market. A very effective use of leverage would be to make pre-market trades using leverage. This will most likely produce huge sums of money for you. Lastly, always remember to use the limit and the stop orders to protect yourself financially and emotionally.

For example. Traders A and B traded on a standard lot of USD/CHF which is equivalent to $100,000 and took the same positions with the same margin-based leverage of 100:1. But trader A applied stop order on his trade for certain limits. The currency pair went in the direction opposite to what they predicted. So they both lost money on that day but trader A contained his loses because of the stop order he implemented but the loss trader B incurred was cataclysmic. Which of these traders would you like to be? We believe trader A will be our first choice. But the opposite scenario could have happened. In this case, they will both make a profit but trader B will most likely make more profit. In both cases, trader A’s position is the best place to be.