Leverage in the foreign exchange market, better known as the Forex market, is used by traders to profit from fluctuations in exchange rates between two different currencies. It is worth mentioning that the leverage that can be achieved in Forex is one of the highest that investors can obtain. Generally speaking, leverage is a kind of “credit” that the Forex broker provides to the investor once he opens an account and is secured by the initial deposit. Generally, the amount of leverage provided can be 50:1, 100:1 or 200:1, depending on the broker and the size of the position the trader is trading. For example, to trade $100,000 in a currency with a 1% margin the trader will only have to deposit $1,000 into his account. The expected leverage for this trade will be 100:1.
At first glance a leverage of 100:1 may seem rather risky, but the risk is significantly lower considering that currency prices tend to vary less than 1% in intraday trading.
Although leverage is a tool that allows for significant benefits, it is important to keep in mind that it can also work against investors. For example, if the currency underlying one of your trades moves in the opposite direction of what you thought would happen, leverage will greatly increase potential losses. To avoid this catastrophe, forex traders often implement a strict trading style that includes the use of stop-loss.
Leverage applied in excess can literally wipe out a trading account. Suppose we have funds in an account for $10,000 (our margin), and we decide to use $2,500 of 400:1 leverage to buy $1,000,000 of a given currency. Unfortunately, the trend is reversed and the market moves 100 pips against it. If we talk about a dollar this means only one cent; however, in the case of the trade we are making, this becomes $10,000. In other words, all the funds in our account will now be used to cover the losses.
At this point, or even earlier, the broker will make a “margin call”. This means that the broker will close the trade, without consulting us, using all of our $10,000 to recover the money we borrowed through leverage (brokers never lose), leaving our account empty.
Unfortunately, this scenario is not uncommon. Even if a trade is ultimately positive, a sudden rise or fall in the exchange rate right after you open your trade may be enough for a “margin call” to end your transaction. The question is, how can leverage be used to generate reasonable profits for us, avoiding disastrous losses?
The following steps will help you apply leverage more safely:
Use leverage sparingly. There are cases that are already being regulated, such as in the United States, where leverage is limited to a maximum of 50:1.
Use a small part of your margin per trade. 5% might be an appropriate amount. This reduces the overall leverage effect on your account, but it is always important to manage your trades correctly to maximize profits and minimize losses.