How leverage works in forex trading?
Leverage is one of the most misunderstood financial tools used by Forex traders, yet it can be a precious tool if used correctly..
Leverage helps Forex traders amplify their returns on investment without requiring them to increase their capital.
What is Leverage & How Does it Work?
Check out our FSA superstore for top-quality trading tools and services. Leverage is a financial tool that allows traders to control a more prominent position in the market with less capital.
This is done by borrowing money from the broker, which amplifies the trader’s profits (or losses) on any given trade.
When trading Forex with leverage, a trader borrows a certain amount of cash from their broker to control a more prominent position in the market.
For example, if a trader has a $1,000 account and uses 1:100 leverage, they would be able to trade places worth $100,000
If the trader makes 10% on their position, they will make $10 for every $1,000 they have in their account – including the initial investment and the borrowed money.
On the other hand, if the trader loses 10% of their trade (in this case, $100), they will lose $1 for every $1,000 they have in their account. The broker would keep the initial investment and the borrowed funds until the position is closed out – regardless of how deep into an unfavourable work the trader goes.
For example, suppose a trader has a total account value of $500 ($1,000 account balance +$500 in profits =$1500 total) and a long EUR/USD position in their trading account with an entry price of 1.3000, a stop-loss order set to break-even at 1.2950 plus 5:1 leverage when the pair moves against the trader by 50 pips (1.2900). In that case, the position will have been stopped out, losing $500 (50 pips x $10 per pip = $500).
How to Use Leverage to Your Advantage
Now that you understand how leverage works, it’s essential to use that information to your advantage.
Here are some tips for using leverage successfully in Forex trading:
- Use a conservative amount of leverage when starting – as a beginner, it’s best to stick with lower leverage ratios until you gain more experience with Forex trading. Too much leverage can lead to significant losses if you’re not careful
- Make sure you know the risks involved in using leverage – as we’ve stated in this article, if a trader opens a position with too much leverage and their trade moves against them, they could lose more than their initial investment. For example, a trader has a $1,000 account balance and uses 4:1 leverage to open a long EUR/USD position at 1.3000, with a stop-loss order set on the other side of their entry (at 1.2950). If the pair moves 50 pips against the trader (to 1.2850), their stop-loss would be triggered, and their position would be closed out for 123 pips – losing 300 pips ($300) on the trade rather than just 50 ($100).
- Use proper money management techniques when trading with high leverage levels -traders who do not use proper money management techniques while trading with high amounts of leverage will be more prone to significant losses due to a few bad trades.
- Don’t jump headfirst into Forex trading – instead, slowly build up your knowledge and experience in Forex before testing out this form of speculative investment
- Understand how the Forex market operates daily, such as when it’s open and what factors affect currency prices
- Make sure you have an account that offers competitive spreads and low commissions, so you don’t lose too much on each trade – even with short positions on the market. Some brokers offer micro accounts to help you get started without spending too much.
Leverage is a powerful tool that can be used to your advantage when trading Forex. By using a small amount of capital to control a more prominent position, traders can amplify their profits (or losses) on any given trade.
However, it’s essential to understand the risks of using leverage before you start trading. If you’re not careful, you could end up losing more than your initial investment.
So make sure you use proper money management techniques and know what you’re doing before jumping into the world of Forex trading!