The notion of leverage is not merely unique when it comes to the forex markets. In fact, leverage is a financial concept implemented in almost all financial markets and all types of trading. But in forex trading you will actually be able to get much higher degrees of leverage for trading than any other market.
This makes leverage that much more important for traders in the forex market. Because just as much as it can provide you with a valuable tool to trade with a higher equity, it can also increase your chances of losing your assets.
Therefore, it is very important to know as much as possible about how leverage works in the forex market and how to implement it to your advantage. These are the subjects discussed in this article.
Leverage: A Popular Concept in Financial Markets
First of all, as it was just referred to, leverage is not only seen in forex. It is a tool used in almost all financial markets. The concept behind leverage trading is actually quite simple and yet elegant.
Imagine you are a trader who knows a thing or two about trading. The knowledge of trading might have been gained in any way or through any means. The only problem is that you do not have enough initial capital to start trading. In this situation, it would prove prudent if you were able to borrow other people’s money and trade with that money. Then, after you have pocketed the hefty profits from the higher initial capital, you can return the original funds to their owners plus a certain amount of fee or commission.
Well, this is exactly what leverage trading is. Exchanges and brokers will provide traders with a higher degree of capital for trading.
Now, let’s discuss further the idea of leverage trading in forex and how it works.
Leverage Trading in Forex Markets
So we learned that leverage trading is when you can trade with a much higher value than your starting capital. This starting capital is usually referred to as initial margin.
Your initial margin will ultimately determine the final amount of leverage trading coupled with the leverage ratio that is offered by the broker.
Of course different brokers offer various rates of leverage to traders. And it also depends on your specific needs and trading conditions to see what ratio of leverage you require.
But, generally speaking, the most common leverage rates in the forex are as follows:
|Common Leverage Ratios in Forex|
|Leverage Ratio||Percentage of Trade|
So the ratio of leverage shows how many times your initial margin you will be allotted for trading. Naturally, for a leverage ratio of 1:100, which is the most common leverage ratio in forex, you will get 100 times your initial margin for trading.
Of course, depending on the leverage ratio, you will have to lock down or deposit a percentage of the trade value within the broker. So, for example, with a leverage ratio of one to two hundred (1:200), provided that you are trading a standard lot size, you will have to deposit and lock down an initial margin equal to 500 dollars.
This is the upside of leverage, where, for example, you are able to trade with a 100,000-unit lot size (standard size) when you only have $500. But keep in mind that there is also a downside. But more on that later.
As was mentioned, the most common forex leverage is 1:100. But depending on the broker, traders might be able to get much higher rates, even as high as 1:1000.
Of course, these rates are clearly very high. But why is such a high leverage ratio commonly made available to forex traders? Perhaps the most prominent reason has to do with the high liquidity of the forex market.
Because the market has a very high trading volume, the liquidity is higher. This means trades are executed faster. Ergo, the less delay between decision making and the actual execution of the trade means traders will be able to manage the risks available with trading much better.
Pros and Cons of Leverage Trading in Forex
Similar to any other tool and technique available to forex traders, there are both positive and negative aspects in forex leverage trading. Let’s discuss the upsides and downsides of leverage in the forex market:
The Advantages of Leverage Trading
Leverage is actually a rather complex financial instrument. So there are many aspects that can be investigated. But the most important upside of leverage is that it will enable traders to have the opportunity to trade with a high capital compared to their initial equity.
Keep in mind that this advantage is two-sided and benefits both the trader and the broker. Because provided that the trader is actually an experienced and skilled trader, the chances are they will be able to make considerable amounts of profit trading with their leverage.
So, they will manage to pocket a higher percentage of profits and the broker will also be able to get higher fees per trade from the trader.
This clear advantage is only if the trader knows enough about trading and does not make mistakes. But what happens if you lose money that you don’t have?
The Disadvantages of Leverage Trading
This is precisely the point where we get to the downside of forex trading. Losing money that you don’t even have.
It’s true that leverage trading allows you to trade much more money and thus be able to obtain much higher profits. But at the same time there is much higher risk of losing money.
Of course, when the stakes are high, the risks are as well.
Although this is a big downside of leverage trading, you won’t actually lose the money you don’t have. In fact, you will lose just as much as you started with.
The only problem is that you will lose your initial capital much faster!
In our example above, with a leverage ratio of 1:200, the trader was able to trade a standard lot size with only 500 dollars.
Now, if this trader goes into loss and loses that initial capital of 500 dollars, the broker will margin call the trader.
When the trader is margin called, it means he or she must deposit money into the account in order to be able to continue trading with the leverage. Otherwise that is it. This is why being margin called is the spooky condition all traders attempt to avoid.
Leverage enables forex traders to execute trades with a higher capital than their starting funds. This extra fund is provided by the broker. depending on the broker, the ratio of leverage can be anywhere between 1 to 50 or even 1 to 1000. Although there are risks associated with leverage trading, if the trader has enough knowledge and experience, leverage trading can be an excellent way of trading in the forex market and making more profits.