If you are new to trading, you must be trying to get familiar with the trading jargon. Also, by now, you must have come across the term ‘leverage in forex trading’ as well. But do you know what it exactly is and how it can be used profitably and effectively?
Leverage in forex opens up a huge window of opportunities for you that your original capital can’t bring you. While it is quite popular and you might be interested in trying it as well, you should understand the term in more detail. You must learn how forex leveraging is done, it’s applications, limitations, upsides as well as its downsides.
So, read on to grasp the concept of forex leveraging to further imply it in your trading ventures!
What does leverage in forex mean?
Leverage is the utilization of the capital borrowed to invest it further in stock, currency, etc. For people regularly involved in Foreign Exchange Market (Forex), financial leverage is a major account booster. It allows you to trade in much greater volume while depositing smaller or limited capital that you own.
This term is gaining high popularity as it considerably decreases the margin levels. It allows an investor to borrow money from a broker and further trade great amounts. This way, leverage increases the potential returns multi-fold during favorable currency exchange rates. For instance, it can open orders up to a thousand times larger than the original account
Forex being an online trading platform, makes the trading experience easily accessible to anyone across the globe. Thus, the financial margin available is wide enough and full of opportunities for the people engaging in leveraging.
The main purpose of leveraging in forex
Given the popularity of margin trading, financial leveraging is mainly used for:
- Expanding the asset base and benefitting from returns on risk capital. This further enhances earnings per share and the ROE.
- Amplifying the earning range.
- As many countries impose tax-deductible interest expenses, leveraging reduces the expenses to some level. This way, the amount to be paid to the borrower gets alleviated to some extent.
Here there are no deadlines to decide when the trader chooses to settle the leverage provided by the broker. Also, there is no interest on the margin. It allows only Swap payments to be made, which again benefits the trader to some extent. For all these reasons, traders have been using leverage in forex to gain more profit than their account balance allows.
How does leveraging in forex work?
The forex market is the largest possible trading marketplace where up to $5 trillion worth of money gets exchanged daily. The entire trading system is based on the buying and selling of the currency exchange rates. This occurs while ensuring that the process pushes the rates in the trader’s favor at all times.
The leveraging system works with quoting or bidding and asking for currency rates with the broker. If an investor chooses to buy a currency, an asking price would be quoted to them. However, when they wish to sell the currency, a bid price would be quoted to them. An investor utilizes the favorable exchange rates to decide when to sell or buy a currency.
For instance, an investor finds a hopeful rise in the Euro to the dollar exchange rate in the near future. So, he will take advantage of the situation and buy Euro in exchange for the US dollar at a low ask price. When the currency exchange turns favorable, and there’s a profitable rise, he will buy euros with the same US dollars.
This way, an investor uses leverage to gain profit via forex trading. Leverage can thus be seen as a loan provided by a broker to an investor.
The impact of initial margin
For new traders, brokers tend to limit the amount of leverage initially. However, with time the trader will be able to decide for himself the trade-size or the leverage of their choice. But an initial margin will still be deducted as a set percentage from the total amount earned from the trade.
This initial margin can vary with the size of the trade you indulge in. For an amount of $1,00,000, you can be charged $1000 as an initial margin of 1%. This can also be denoted as a leverage ratio of 100:1. This ratio depicts the magnification of the trade size due to the initial margin set by the broker.
How to choose the ideal leverage to be used in forex?
Now that you know how leveraging in forex works, you might be wondering how to make a profitable trade. A trader must have a firm trading strategy along with a substantial vision of the market’s movement. This is necessary for you to decide when a trade will be profitable and where you must buy or sell the currency exchanges.
But what is the ideal leverage that must choose? Well, in a forex market, leverage ratios can vary from 1:1 to 1:100 and even more. However, 1:100 is considered to be the most optimal leverage ratio available at forex. It means that for every $1,000 in your account, you can open a position of $1,00,000 and trade it.
Leverage traders can thus trade in significantly high volumes as compared to their actual balance. However, those who do not have enough balance to open adequate trading positions tend to trade on margin. But, which leverage must you choose?
You, as a forex trader, must choose the leverage that is comfortable to you. While high leverages might quite sound appealing, they are equally risky as well! Forex leverage is a double-edged weapon, and you must choose your weapons carefully and after the adequate experience.
Why is forex leverage called a double-edged weapon?
High leverages are considered to be none less than a function of risk by some traders. It offers high trade positions because it has the potential to magnify your profits and losses to the same degree. An investor trades by betting on a hypothetical favorable situation and not a definite situation.
So, while there’s half possibility of the odds being in your favor, the other half is still against you. Also, markets can be rather unpredictable at times, so using high leverages can be as risky as the size of your trade. Thus, while high leverages can be attractive, they can also invite amplified potential loss.
You can find break-out traders or scalpers who utilize high leverages as they are always looking for instant trades. Spot cash markets are quite fluid and thus, entering or exiting a trade position is much easier and favorable here. However, there are also positional traders who analyze the market well and often trade with low leverages.
So, it boils down to the fact that you must leverage amounts as per your ability to manage it. If you have gained adequate experience in trading and can handle the possible risks, you can easily take higher leverages. These factors must be considered; otherwise, you might end up depleting your trading account with heavy losses.
On the other hand, going with smaller leverages in forex will help you to play safe and gain experience. It will leave you adequate space to analyze, decide, and prevent huge losses. As a trader, you can leverage as much as you like.
You can decide how carefully you want to proceed because leverage is a double-edged weapon indeed. Only the experience in handling it well will ensure safe and profitable trading.
How to deal with leverage risk?
As the amount of risk is very high in the case of forex leverages, you must consider risk management too. Forex risk management will help you apply basic rules and measures to avoid any catastrophic impact on your trading account. Effective planning and strategizing before trading huge amounts will make undesirable losses still manageable.
To be able to manage your leverage risk, here are a few things that you can do:
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Grasp the working of leverage in the forex market
Understanding the exact working and analyzing the trends well will enhance your expertise in this area. You will be able to understand which forex market is right for you. Also, analyzing the market movements of currency pairs will further improve your trading skills and ensure more gains.
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Devise trading plans
A disciplined and well-devised trading plan will help you set boundaries and define your paths. Planning your trade approach will help you set goals, ideas and put effective loss management in place.
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Fix a risk-reward ratio
Trading can be risky and can cause significantly high losses. But if you set a proper risk-reward ratio, you can make sure that you are always on the profitable end. By taking overall risks that still leave enough margin for profits, it can be a no-loss situation.
Final takeaways
The forex market can be highly volatile, and leverages bear huge risks. But experience and fine risk management will help you to ride the dicey trading market with confidence.
While it can offer you substantially high trade positions and attractive leverages, you must proceed carefully. Leverage in forex is a double-edged sword, after all, it must be handled with adequate care.