The Forex trade market has a distinct special feature that allows you to earn enormous profits fast- leverage. However, you have to use Forex leverage wisely as it can also bring you big loses fast,...
What is leverage in forex trading?
When an investor decides to invest in the forex market, he or she must first open up a margin account with a broker. Usually, the amount of leverage provided is either 50:1, 100:1 or 200:1, depending on the broker and the size of the position the investor is trading. ... The leverage provided on a trade like this is 100:1.
What is a leveraged product?
Leveraged products are financial instruments that enable traders to gain greater exposure to the market without increasing their capital investment. They do so by using leverage. Any financial instrument that allows you to take a position that is worth more on the market than your initial outlay is a leveraged product.
The Forex trade market has a distinct special feature that allows you to earn enormous profits fast- leverage. However, you have to use Forex leverage wisely as it can also bring you big loses fast, and even wipe out your investment completely.
Here's how Forex leverage works. You will have the power to trade your one (1) dollar capital to a position worth one hundred (100) dollars and generate profit from the one hundred (100) dollars, working on a ratio of 1:100. The leverage rates in Forex can go very high depending on the offer of the brokers. Do you now see the potential of earning huge profits just by leveraging?
But there's a downside to this feature. The risk of incurring big loses is equal as that of earning your huge profits. What this means is that with the ability of Forex leverage to transform the trade one (1) hundred times bigger, you are also capable to lose your capital by as much. Again, based on a ratio of 1:100, if the trade goes against your favor, you can lose your entire capital even on a single trading with leverage.
It is crucial therefore to know how and when to use Forex leverage to your advantage. Leveraging is used by Forex brokers often to attract people to trade big so the brokers themselves can earn big, as they earn
interest from the amount that they lend you as leverage.
Forex leverage is an easy tool to earn big profits from the trade as long as you learn how to use it judiciously. You should be able to balance the upside and downside of leveraging to earn optimum results with minimal risks.
To determine margin-based leverage, divide the total transaction amount by the level of margin you are required to put up. (For more insight, check out Margin Trading.)
|Margin-Based Leverage =||Total Value of Transaction|
For example, if you're required to deposit 1% of the total transaction amount as margin and you are trading one standard lot of USD/JPY which is equivalent to US$100,000, the margin requirement is US$1,000. So, your margin-based leverage is 100:1 (100,000/1,000). For a margin requirement of 0.25%, the margin-based leverage is then 400:1.
To determine your real leverage, divide the total face value of your open positions by your trading capital.
|Real Leverage =||Total Value of Transaction|
|Total Trading Capital|
For example, if you have $10,000 in your trading account, and you open a $100,000 position (one standard lot), you will be trading with 10x leverage in your account (100,000/10,000). Now, if you trade two standard lots($200,000) with $10,000 in your account, then your leverage on the account is 20x (200,000/10,000).
Risk of Excessive Real Leverage
So as you can see, real leverage has the ability to magnify your profits or losses by the same magnitude. The greater the leverage you use, the higher the risk that you take on. Keep in mind that this risk is not necessarily related to margin-based leverage, but it can influence if you're not careful.
Take a look at the chart below to see how the trading accounts of these two traders compare after their 100-pip losses.
|Trader X||Trader Y|
|Real Leverage Used||50 times||5 times|
|Total Value of Transaction||$500,000||$50,000|
|In the Case of a 100-Pip Loss||-$4,150||-$415|
|% Loss of Trading Capital||41.5%||4.15%|
|% of Trading Capital Remaining||58.5%||95.8%|
|Figure 1: All figures in U.S. dollars|
Excessive Leverage Can Kill
By allotting a lesser amount of real leverage on each trade, you can give your trade a little more room for error by setting a wider but reasonable stop thus avoiding risking too much of your money. Highly-leveraged trades that move in the wrong direction can eat up your capital quickly due to larger lot sizes. If you only remember one thing from this, remember that leverage is totally flexible and customizable to your needs, so be sure to use leverage wisely and don't go for that home-run every time.