Forex trading is popular among traders because it allows for considerably greater leverage than stocks. Although many traders have become aware of the phrase “leverage,” few understand what it means, how it works, and how it might harm their wealth. This article will assist you avoid all of that while also educating you on the benefits and drawbacks of leverage.
What is Leverage in Forex?
Forex traders can use leverage to boost their exposure to the forex market. They can manage a larger trading size with less capital. Because they rely on the whole value of the position, this could result in higher gains and losses.
Leveraged forex trading, also known as forex margin, allows you to maximize profits when the market moves in your favor while simultaneously exposing you to the danger of an entire loss if the market goes against you. Profit and loss are determined using the overall value of the trade, not only the deposit amount.
How Does Leverage Work?
Forex traders often use leverage of up to 100:1. This means that you can trade up to $100,000 in value for every $1,000 in your account. Many traders believe that because leverage is a form of risk, forex brokers provide such high leverage. They would not offer the leverage unless they were certain that the account would be well-managed and that the risk was highly manageable. Forex markets offer greater liquidity, making it easier to initiate and exit deals at your preferred level compared to less liquid markets.
We measure currency movements using pips, which are the smallest change in currency price and a trading unit. In reality, these adjustments only cost a few cents. For example, when the GBP/USD currency pair moves from 1.9500 to 1.9600, the exchange rate increases by merely one penny, or 100 pips.
As a result, enormous sums of money must be exchanged for little price changes to convert them into larger profits, which are then amplified via leverage. When dealing with a large sum like $100,000, little swings in the currency rate can have a significant impact on your profits or losses.
What is Margin?
The margin refers to the total amount of money required to open a leveraged deal. Margin trading requires a deposit of only a part of the overall position value. Margin rates for prominent currency pairs, including EUR/USD, USD/JPY, and GBP/USD, typically start at 3.3% but may vary by broker.
Any deposits made to keep open positions are maintained by the broker and are referred to as “used margins.” Available equity, or “margin level” when expressed as a percentage, is any money that is available to open more positions.
A margin call occurs when your margin level goes below a predetermined threshold, putting your positions at risk of liquidation. Margin calls should be avoided because they lock in a trader’s losses, so keep a watch on the level of margin. Risk management measures can help reduce the chance of margin calls.
The Risks of Leverage in Forex
Leverage can either increase or diminish earnings proportionally. The amount of risk you take increases as you add leverage to your capital. However, if a trader is not cautious, it can have an impact on their profits and deals. It should be noted that this risk is not always associated with margin-based leverage.
Let’s use an example to illustrate this concept. There are two traders, both dealing with a broker who requires a 1% margin deposit, and both have a trading capital of $10,000. After conducting some research, they both believe that USD/JPY has reached a peak and will fall in value. As a result, they both have a USD/JPY short position at 120.
Based on their $10,000 trading capital, Trader A intends to utilize 50 times real leverage on the trade by shorting USD/JPY for US$500,000. Given the current USD/JPY exchange rate of 120, one pip of USD/JPY is worth about $8.30 for one standard lot and $41.50 for five standard lots. Trader A will lose 100 pip, or $4,150, on this trade if the USD/JPY rises to 121. A single loss will account for an incredible 41.5% of their trading capital.
Trader B, a more cautious trader than Trader A, uses five times the actual leverage to short US$50,000 of USD/JPY with a trading capital of $10,000. The USD/JPY sum of $50,000 is only comparable to half of one ordinary lot. Trader B will lose $415, or 100 pip, on this trade if USD/JPY rises to 121. As a result, this single loss accounts for 4.15 % of their whole trading capital.
How to Avoid Leverage Risk
Leverage trading may be considered a way to improve your forex profits, but it also raises your risk exposure. As a result, using leverage in the forex market necessitates having a solid risk management strategy in place. The following are some risk management techniques you can implement to reduce the hazards associated with leverage trading.
Stop Losses
A stop-loss order allows you to exit a trade if it shifts against you at a specific price, reducing your losses in a negative market. In general, you are specifying the level of risk you are willing to tolerate in the trade. Even with a stop-loss in place, slippage makes it impossible to guarantee the closing price.
A trailing stop-loss acts similarly to a regular stop-loss. When the market moves in your favor, the trailing stop-loss adjusts to reflect the upward price movement.
A guaranteed stop-loss order (GSLO) will always be completed at the specified price, regardless of market volatility or gaps. You must pay a premium when your order is delivered to take advantage of this benefit. The premium is reflected on the purchased ticket. If the GSLO is not triggered, the payment is refunded.
Take Profits
Take-profit orders function similarly to limit orders in the sense that they are always filled at the target price you select. Any positive slippage will be passed along to the buyer if the market opens at a more favorable price than your target price.
Conclusion | Leverage in Forex
There’s no need to be terrified of leverage once you know how to manage it. If you allow your transactions to run unsupervised, you should never use leverage. Otherwise, with proper management, leverage can be used efficiently and productively.
Using less real leverage on each trade provides for more flexible but realistic stops and reduced capital losses, allowing traders more breathing room. If a highly leveraged trade goes bad, it can quickly deplete your trading account because larger lot sizes result in greater losses. Remember that leverage can be adapted to match the demands of any trader.
