What is Leverage in Forex?
Have you opened a new trading account and want to understand what is leverage in Forex?
Leverage is one of the most powerful and alluring aspects of choosing to trade forex over most other asset classes. But what actually is leverage in forex and how can you use it to your advantage?
Leverage allows a Forex trader to essentially borrow money from your broker, for the purpose of controlling a larger position than you could otherwise trade. Through what is essentially a loan from your broker, leverage allows you to use a fraction of your own money, while still being able to trade much bigger volumes than you otherwise could.
An example of leverage in forex:
Leverage is expressed in ratios, such as 1:100.
Using leverage of 1:100, you would only need $1,000 in your account, to control a $100,000 position.
This $1,000 in your account is what’s known as margin. Essentially a good faith deposit made to your broker before they stump up the rest needed to take the larger position.
In this blog, we go over the benefits, risks and speak about why you need to focus on risk management rather than simply bumping up your leverage.
Does Leverage in Forex Really Increase Trading Profits?
No, leverage itself alone doesn’t increase your trading profits. Don’t be ridiculous, leverage is not some magic wand that waves across your Forex broker’s account and makes you money. Taking personal responsibility for your strategy and risk management rules is the single most important factor when you’re trading on leverage.
To show how leverage affects your trading profits, let’s revisit the example we spoke about above:
So as we already showed, to control a $100,000 position using leverage of 1:100, you only need $1,000 in your account as margin. The rest is fronted by your broker, essentially loaning it to you so you can trade respectable size in the 5.1 trillion dollar a day forex market.
Without leverage, if you had invested that entire $100,000 of your own and its value had appreciated to $101,000, then congratulations, you would have made a 1% return on your investment. While profit is profit, that’s not the sort of return we trade Forex for, is it?
But as your Forex broker offered you leverage of 1:100, allowing you to control a $100,000 position while only investing $1,000 of your own money as margin, you’d have now made a 100% return. Now that’s more like it.
This is the power of using leverage as a Forex trader.
Forex Leverage is a Double-Edged Sword
But if something is too good to be true, then it probably is. We’re sure you’ve heard the saying. Well, over-leverage is where new traders often find themselves getting into serious trouble. Learn how to calculate swaps in Forex.
Leverage in Forex truly is a double-edged sword. While we could feel you cringing through the screen as you read that bashful cliche, it’s a fact that simply had to be stated for your own well being. If you’re not careful, then leverage will do more harm than good to your psychology and most importantly your account balance.
This is because if we use the above example for a third time, only this time picturing your position moving against you $1,000 (shudder), you would have also lost 100%. That’s right, your entire investment, gone in one single market move.
You can read all about what leverage is inside forex inside blogs just like this one all you want, but until you’ve experienced the highs and lows on a trading account yourself, you probably won’t understand.
For this reason, we encourage you to open a small live account rather than a demo account, in order to really feel what leverage does to your account and most importantly, your psychology.
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Risk Management is Still the Key to Profitable Forex Trading
The single most important aspect of using leverage in Forex is to use what your broker offers you effectively. This means remaining a risk manager first and foremost and sticking to your guidelines laid out in your trade plan.
In order to do this effectively, never risk more than 2% of your account’s equity on any single trade and make sure you’re taking positions that offer excellent risk-reward ratios. By keeping your risk low and allowing your winning trades to run, you’ll put yourself in a much greater position to become consistently profitable than if you just maxed out your leverage and gambled on 50/50 moves.
Remember, just because you have access to leverage of 1:400 or more, doesn’t mean you have to use all of your available margin on any single trade. Instead, consider using a position size calculator tool to ensure you’re always sticking within your 2% risk parameters and not gambling your entire account on a single move.
If you want to leverage up and gamble on a single move, you honestly may as well just go down to the casino and put it all on red. At least that way, you’ll get a few free drinks out of the experience!
Final Thoughts on What is Leverage in Forex?
In conclusion, while using leverage in Forex to quickly scale up your profits can be tempting, the key to becoming a consistently profitable trader is employing conservative risk management tactics as a part of your overall trading strategy.
After reading about what is leverage in forex, you should now realise that the ratios offered by your broker aren’t going to make you rich alone. Instead, they have the potential to really set you up for failure and on the path toward a dreaded margin call.
There is no right amount of leverage that you should use to be successful, but there is a wrong amount of risk. No matter your leverage on offer, always adjust your position size to only risk 2% of your account equity per trade.
You won’t double your account overnight, but by managing risk effectively, you will stay in the game long enough to double it many times over in the long run. Forex trading is a long term game after all.
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