Understanding The Significance Of Leverage In Forex Trading

When did you read or hear something about forex trading for the very first time? Can you recall it? Maybe it was an ad or a blog about it. For me, I stumbled upon a video on YouTube and the rest is history. It is hard to miss the buzz that the forex market has created. I am pretty sure that you must have been sceptical about it in the beginning. Perhaps you even doubted if it was legit or just another Ponzi scheme for being heavily promoted. 

Why is everyone turning towards currency trading? Is it really better than trading other assets?  The high leverage can be a reason for the hype and attention that the forex market is getting. But you have to learn a lot about leverage before placing leveraged trades because it is a double-edged sword that must be handled carefully. 

So, let’s dive into the topic and keep reading till the end to get some powerful tips that you can follow for getting the best results while trading with leverage. 

How To Trade More With Less Using Leverage? 

Leverage allows traders to open higher positions with less capital. For example, if your trading account balance is $500, and you are getting a leverage of 100x from your broker, then you can open a position as big as $50,000. This will amplify your profits, but at the same time magnify losses as well. 

You just have to maintain a small percentage of total funds that will be risked for the larger trade position as collateral. This is specified as margin requirement by the broker and the required margin amount will get smaller with higher leverage. That’s why it is also known as margin trading and a margin calculator can determine the margin requirement for your trades from the details you enter. 

This simple tool calculates the amount of funds needed to meet the margin level based on your trade size in lots and leverage ratio. It can even convert the amount to a currency of your choice by applying real-time exchange rates. If you forget about margin calculations, a margin call will be triggered once the account balance falls below the required level. The broker will ask you to deposit the needed amount right away. If you don’t add the funds, your positions will get squared off automatically.  

How Leverage Works In Forex Trading?

You must learn the concepts of leverage ratios to manage your risk properly in the market. By learning about ratios, we will get a better idea of the role of leverage in the actual trading process. 

• 1:1 

When you are not using any leverage, the ratio will be 1:1. This means for entering a trade position, you will have to maintain 100% of the total funds as margin in your account. So, if you want to place a trade of $1000, you must have that much money in your account and again you have to keep the risk per trade to 2% or 3% of the account balance. So, you cannot risk all the funds in your account for a single trade. So, the amount you use for placing an order should be proportional to the percentage of capital you can risk. 

• 2:1 

When the leverage ratio is 2:1, you just have to maintain 50% of the total trade amount as a margin. In the previous example, we needed $1000 to place a $1000 trade but here we will only need $500 to get the same trading power. Your profits will be doubled when you win and so will be your potential losses if the trade doesn’t work. However, it does give more freedom to a trader in the sense that they have more free margin in the account even while placing larger-sized trades.   

• 20:1

With this leverage ratio, your trade size will be 10x amplified in comparison to the 2:1 ratio. You can place a $20 trade with every $1 in your account which means you can make 20 times more profit if you have a solid strategy in place. But you should also be prepared to lose more if the market moves against your expectations. 

• 100:1 

This is actually the most preferred leverage ratio in the forex community. It is quite high but still not too risky. If you want to place an order that needs $1000, you will just need to maintain $100 as collateral or margin for the trade. Those who have a low-risk appetite can choose 50:1 too. Just the margin requirement will be higher and the trade size will be 50x bigger. 

• 500:1 

Amplifying your trade size by 500x is a big decision and it is definitely not recommended unless you have enough experience and expertise to deal with the risk. Traders who use this high leverage mostly enter smaller sized trades and most of them are professionals with a high win rate. 

So, higher leverage means lower margin requirement and a great increase in position size. But it also means higher risk and a bigger account drawdown when you lose. 

You can use advanced tools like trading calculators to determine the outcome of your winning trades in advance. Then, you can adjust the entry and exit prices to get the optimal result. 

What Can Go Wrong While Trading With Leverage? 

• Leverage is borrowed funds, so irrespective of the losses, you’ll have to pay it back to your broker. 
• When you encounter losses, leverage can wipe out your trading capital triggering a margin call. 
• Besides increasing risk, leverage can also lead to habits like over-trading. Because of these demerits, we have to use leverage within a limit. 

Tips For Prudent Leverage Utilisation

• Understand The Risks – The first thing to do before using leverage is to understand the risk that comes with it. We have to consider our own risk appetite for choosing an ideal leverage ratio.
• Broker Selection – Many traders just trade with a broker offering higher leverage but we need to make sure that they are regulated and offer negative balance protection to safeguard our account while using leverage. 
• Pay Attention To Position Sizing – We should only risk 1% to 2% of our trading capital for a single trade and decide the optimal position size based on this. When we rely on leverage, the trade size will be magnified but we still need to limit the risk per trade. 
• Start Trading with Lower Leverage – Being a beginner, you should start with a lower leverage ratio to minimise the risk. You can gradually increase it after gathering more experience. That’s what I did in the initial phase of my trading career. 

Final Thoughts

Finally, leverage can accelerate your trading journey allowing you to grow your account with greater ease. But you should not underestimate the risk that comes with leverage and prioritise risk management to trade safely. In the end, leverage is nothing more than a tool and the end result depends on how well you can use it as a trader.