Unlike other financial assets, forex affords traders the luxury of trading with extremely high or low leverage. Leverage is simply a trading tool that makes it possible for forex traders to control larger capital and increase the buying power of their deposited funds. By doing so, the deposited funds can buy and sell larger orders and empower the trader with the ability to compound the capital quickly. Leverage is indeed a powerful asset to every forex trader, and if you want to take advantage of it, you need to understand it. As always, we have researched for you, and in this article, you will learn all you need to know about forex trading leverage. Let’s begin!
What is Forex Trading?
Forex trading involves the exchange of currencies via spot trading or futures contracts.
These currencies can be traded in pairs – one is bought while the other is sold simultaneously.
How Does Forex Trading Work?
To profit from forex trading, you need to buy strong currencies and sell weak ones on a forex brokerage platform. To determine the relative strength of a currency, you have to carry out technical analysis of price charts and fundamental analysis of news and economic data.
How Leverage Works in Forex Trading
Leveraged trading involves using borrowed capital to trade larger forex trades than your capital would ordinarily allow. For instance, some brokers can offer leverage of up to 500:1. This means that every $1 in your trading account has a buying power of $500. The high leverage allows traders to take advantage of the liquid forex trading environment.
Forex traders profit from fluctuations in currency prices measured in pips. A pip is the smallest measurable price fluctuation. Leveraged trading allows you to trade the smallest price movements (such as a 0.2 cents fluctuation) and make large profits regardless.
Here are some commonly used terms relating to forex leverage;
Margin
Margin is the amount you must deposit to your brokerage account to open a trading position. Since most traders use leverage, the margin is often expressed as a percentage of the amount of the position you have opened. Brokers have different margin requirements, ranging from 1% to 2.5%. Your broker’s margin requirement determines the maximum leverage that can be used on your trading account.
A margin requirement of 0.25% gives maximum leverage of 400:1 (100 divided by 0.25 equals 400).
A margin requirement of 2% gives maximum leverage of 50:1 (100 divided by two equals 50).
For example, if you need to execute a position worth $200,000, your broker can set aside $2000 from your trading account. This gives you a leverage of 100:1 because you’re controlling $200,000 with $2,000.
Margin Call
You can get a margin call when your equity isn’t sufficient to cover your potential losses. When you get a margin call, you’ll be required to deposit more funds into your trading account to increase your equity. If not, your open trades may be closed at the current market prices.
Used Margin
Your used margin is the portion of your capital that your broker has set aside to cater to your open trades. Your used margin can be returned to you when a trade position has been closed.
Usable Margin
The usable margin is the trading capital that is available for use. This allows you to open and manage new trading positions.
Account Balance
Your account balance is the total amount of money you have in your trading account.
What is good leverage for trading in the forex market?
As a forex trader, the leverage you decide to trade with is entirely up to you. You can tailor your leverage to meet your trading needs and requirements. However, new traders are encouraged to trade with low leverage and risk between 0.5%-1% of their capital per trade. Most forex traders use 100:1 leverage to trade, but let’s discuss the factors to consider while choosing your forex leverage.
Factors You Should Consider While Choosing Leverage in Forex Trading
Here are four factors to consider while choosing a forex leverage.
Size of Your Trading Capital
Before deciding on your trading leverage, you have to factor in the size of your trading capital. Leverage allows you to control more money than you actually have. Therefore, the first step to choosing the proper leverage is to define your trading capital and decide how much leverage would provide the purchasing power that you require as a trader.
Traders with significant trading capital often require lower leverage since they already have significant purchasing power.
Your Risk Appetite
Forex traders have different risk appetites. Conservative traders generally trade with the lower risk per trade (0.25% to 1%) and would usually require low leverage. Aggressive traders trade with a high risk of 1% to 3% per trade and may require higher trading leverages.
Nature of Your Trading Strategy
Some trading strategies require traders to trade with high leverage due to the nature and duration of the executed trades. Swing traders who execute fewer trades compared to scalpers may require low leverages. Scalpers may execute multiple trades daily or simultaneously, hence may need higher leverage to take advantage of the liquid forex trading environment.
Number of Assets Traded
Traders who execute multiple trades on different forex pairs or assets will require high leverage to meet the margin requirements.
Risk of Leverage in Forex Trading
Trading with leverage in forex allows traders to make profits quickly but equally exposes them to the risk of losing money quickly. New traders often give in to the lure of high leverage and take on more risk than their trading plan allows. Trading platforms that provide high leverage also give traders access to several risk and trade management tools to help them preserve their trading capital. Some of these tools include;
Stop Loss Orders
A stop loss is an order that instructs your broker to close out a trading position once the price trades to a specific level. It helps you limit your loss and control risk while trading with leveraged accounts. A trailing stop loss is a stop loss order that moves as price trades in your favor. It helps you lock in profit and avoid having a winning trade turn into a loser. It’s a great trade management strategy used by different types of traders, especially trend traders.
Take Profit Orders
A take profit order instructs your broker to close a trading position in profit once the price trades to a specific level.
Frequently Asked Questions About Forex Trading and Leverage
What does a 500: 1 leverage mean?
A 500:1 leverage means that every $1 you deposit has a purchasing power of $500. Depositing $1,000 on an account with this leverage helps you trade positions worth $500,000.
What does a 100:1 leverage mean?
A 100:1 leverage means that every $1 you deposit has a purchasing power of $100. Depositing $1,000 on an account with this leverage helps you trade positions worth $100,000.
Does Forex Leverage Affect My Trading Profit?
Your profits as a trader largely depend on the profitability of your trading strategy and the strength of your trading psychology. While leverage affects the number of trades you can execute, your success largely depends on your trading skills.
Open A Demo Forex Trading Account with Decode Global!
Leverage is a key factor that contributes to the risk/reward equation in trading. At Decode Global, we offer a variety of account types with different levels of leverage to suit your individual needs. We invite you to open a demo account with us so that you can experience first-hand the benefits of trading with leverage. With our forex trading platform, you will be able to trade confidently and profitably using leverage while learning about some of the most complex financial instruments available.Learn everything you need to know about leverage and how it can help increase your trading profits.