In this article, we will discuss the principles of trading with leverage. It allows a skillful trader to increase their potential profit.
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What is leverage in Forex?
Trading with leverage means opening a position for a larger sum than you have on your account. This is done by marginal crediting. In essence, leverage is the ratio of your capital and loaned money. In Forex, leverage is provided by your forex broker; usually, it is increased to 1:100 and more. This is explained by the relatively low volatility of currencies compared to stock and other markets.
The idea of trading with leverage is that currencies are never provided for real. Trading pursuits making a profit on the growth or falling of the exchange rate of a currency pair. All trades with leverage are two-sided: if you open a buying position, you close it with a selling one, and vice versa. As a result of the trading operation, the trader gets a profit deposited on or a loss withdrawn from their trading account.
Thanks to leverage, even traders with a small deposit can open substantial positions in Forex. For example, owning just 1,000 USD on their account, a trader can use the leverage of 1:100 (provided by their broker) and open positions for the general sum of 100,000 USD (1,000 * 100).
Why do we use leverage on Forex?
Traders at work track the movements of currency pairs in points, which is the minimal step of a price change. Such steps are, indeed, just shares of a cent. For example, when EUR/USD grows by 100 points from 1.1700 to 1.1800, this is considered a generous market movement, but in fact, the exchange rate changes by just 1 cent. Hence, to feel your profit from the movements of a currency pair, you may need leverage.
For example, for those 100 points of the profit from EUR/USD to turn into 100 USD, you need to open a position for 10,000 USD (0.1 of a standard Forex lot). For many beginners, this sum will be impossible; however, with normal leverage of 1:100, you only need to have about 120 USD on your account to open such a position.
The larger the leverage, the larger position you can open on your account. The main thing is to remember about the risks: the use of leverage is a two-sided medal, you can earn a lot and lose a lot. So stay vigilant and earnest.
Which leverage to choose for trading in Forex?
For Forex beginners with little to no experience, I recommend small leverage, such as 1:10. This means your trading will start with moderate risks, which is good because you will have a lot of losing trades while you learn. As a rule, brokers allow you to change the size of your leverage, thus, as soon as you become more confident, you will increase your leverage to 1:100 and more.
An important parameter that you must keep in mind is the size of the margin security. For each financial instrument, the broker sets certain marginal security — a sum that you must have on your deposit for opening a position. If there is a floating loss in an open position, and the security sum drops to the minimum (the Stop Out level), the broker will automatically close the losing position.
Hence, you should decide in advance upon the instruments you are going to trade and calculate your suitable leverage based on the marginal securities. For experienced traders, increased leverage is admissible (1:100, 1:200, 1:500) because they know how to control risks in every trade by altering the lot size and placing the Stop Loss.
The risks of using leverage
High leverage increases risks. With leverage, not only your profit grows faster but your losses do so. Mind that your leverage works in both directions, so stay responsible. Surges in market quotations in the case of large leverage may lead to huge losses.
Risk control is an important part of trading. You can regulate your risks not only by the leverage but also by choosing your lot well and placing SLs. You can learn to control your risks by the rules of money management.
Money management is a way of managing your assets by a certain pattern. In other words, this is a way to decide upon the amount or share of your capital that you risk in each trade. Only good money management can protect your deposit and bring further profit.
Leverage is a useful trading instrument that, however, requires caution. In skillful hands, leverage can increase your profit, in inexperienced hands — lead to losses. If your leverage is large, always control your risks by the main rules of money management.
By Dmitriy Gurkovskiy, Chief Analyst at RoboForex