Using leverage in forex trade can increase your profits significantly. However, you must understand leverage to use it correctly.
Some traders find this concept confusing, and it discourages them from trading Forex. Are you this kind of forex trader?
In this article, we will help you understand leverage and how to utilize it to increase your profits when trading forex currency.
What does "leverage" mean in Forex?
Leverage is a term used in forex trade to describe a loan from forex brokers that enables traders to open large trading positions. It is usually expressed as a ratio such as 1:10 or 1:20.
Each forex trading account has a margin requirement. This amount is represented in a percentage that determines how much money you should deposit in your trading account to qualify for leverage.
The trading positions you can open using leverage are much larger than the balance in your margin accounts.
For example, if you want to open a trading account with a 10 percent margin and would like to trade a position worth $ 100,000, you would need to deposit a capital of $ 10,000 in your margin account.
The $ 100,000 in this example is the leverage amount. In this case, you would be trading using a leverage ratio of 1:10.
So, you would get a $ 10 loan from your broker for each dollar in your margin account.
This example shows you how leverage is a tool of trade you can use to control a large trading position in Forex by depositing a small amount of capital in your trading account.
Leverage allows you to profit from small price movements in the forex market.
For instance, using this leverage ratio of 1:10, where you've deposited $10,000 to get $100,000 from your broker, if the currency exchange rate moves by 1 percent, you would make a profit of $ 10,000.
In this way, trading leverage increases your profit margin. It is also a good way of raising more capital from your broker for forex trade.
But you must understand how to use this forex trading tool to avoid making losses. The first place to start is knowing how to manage your margin account/capital.
What is a margin account?
All spot forex traders conduct their trades within a margin account where they keep their trading capital.
The money in these accounts acts as a deposit that allows these traders to borrow funds from brokers to control large trading positions.
You can only get leverage from a broker by depositing some money in your margin account. This capital determines how much leverage you can get from the broker.
You may trade on zero leverage, using only the capital in your margin account to place trades.
This may earn you some profits and minimize your losses, but using leverage allows you to open large trading positions you could not open using your capital.
Leverages are represented in ratios. For example, 10:1, 20:1, and 30:1.
The number on the left is the multiplier. It indicates how much you can maximize your capital.
A 30:1 ratio means you can get 30 currency units from your broker for each unit you've deposited in your margin account.
So, if your margin account has $ 10,000 using a leverage ratio of 30:1, you could open a trading position worth 30 x 10,000, which is 300,000. This means you've used $ 10,000 as collateral, and your broker has lent you $ 290,000.
This gives you more money to trade with on loan from your broker.
If you make wise trades, opening a margin account and leveraging your capital can multiply your profits, but if not, it increases your losses.
What is the right leverage to use when trading Forex?
Several factors determine how much leverage a trader uses when trading Forex. Some examples are trading style, budget, risk tolerance, and investment objectives.
You can lose all your leverage when trading because of unforeseeable events that cause a rapid shift in the forex exchange market.
An example is a market gap when the price of a currency pair moves up or down several pips during a lax trading period.
This will create a visible gap in the currency pair chart pattern, leading to heavy losses for overleveraged traders.
Usually, the forex brokers offering the highest leverages are in jurisdictions with few consumer protection laws or high-risk trading regions.
Otherwise, jurisdictions with adequate consumer protection have laws that encourage low leverage.
In the European Union, the leverage is restricted to 30:1, while in the US, leverage is limited to 50:1.
However, it's best to choose low leverage rates such as 1:10 and 1:20 to minimize losses and avoid liquidation calls.
Benefits of leverage in Forex
Leverage is a powerful tool in Forex for the following reasons.
- It allows those with limited capital to make substantial profits by borrowing additional funds from brokers.
- It magnifies a trader's profits. Traders who use leverage can control larger trades, which gives them access to higher profits.
- It increases market exposure by opening up more trading opportunities to forex traders that they could not otherwise access for lack of capital, such as in commodities.
- It enables traders to diversify their trading portfolio and mitigate risks by allocating capital to multiple trading positions and diversifying their trading strategies.
What is a liquidation call?
You may lose all your trading capital and the money your broker has loaned you through leverage by placing a losing trade.
Forex brokers use margin/ liquidation calls to avoid such occurrences. This is an alarm to close or stop a trade to minimize losses.
These alarms are triggered by stop-out levels and margin requirements set by brokers to protect themselves from excessive losses.
Stop-out levels are controls that prompt a trader to close a trade when it becomes unprofitable to avoid losing all their capital.
Margin requirements are the minimal qualifications for keeping a margin account open. This is the minimum amount you should have in your account to trade and cover potential losses after a risky trade.
When traders make a margin call /liquidation call, they keep your account from going into the red to enable you to preserve some of your capital for future trades.
When traders receive a margin call, they must either close out some trading positions or deposit more funds in their account to meet margin account requirements.
If traders do not respond to margin calls promptly, they may face forceful liquidation. This may lead to the closing of a trading account.
How to manage risks in forex trade
While leverage enables you to maximize your profits, it would be best to safeguard your capital by managing your leverage risk wisely. Here are some strategies:
1. Understand how leverage works
You will lose your capital if you don't realize that leverage is just a tool to borrow money you must repay.
Therefore, you should understand how leverage works and the consequences of utilizing the leverage ratio you choose.
This will let you know how much you can risk in a leveraged trade and whether you can afford it.
For example, it's wise to use a 1:10 or 1:20 leverage, but leverage of 1:400 is too risky.
2. Determine your risk tolerance?
Your financial capacity will determine your risk tolerance.
It's best to use a conservative trading approach to manage risks effectively. As mentioned above, choose low-leverage ratios to balance your risks and protect your profits.
Some factors to consider when determining your risk tolerance are;
Your financial capacity ( the money in your margin account, also referred to as capital)
Your risk appetite (how much you can afford to lose on a trade)
Your trading objectives (the profit you want to make in a trade)
A 1:10 or 1:20 leverage ratio is an excellent place to start before you understand the forex market.
3. Use risk management strategies
You must be proactive about minimizing the money you can lose in a trade if things go wrong.
This will involve using risk management strategies such as "stop-loss orders" and "take loss profits" to minimize losses and secure the profits you are aiming for.
Stop losses are predefined exit points set by brokers to minimize your losses if things go wrong during a trade.
This technique saves traders from losing all or most of their margin account balance on a trade.
It also disciplines forex traders when trading is fevered, keeping them from making rushed decisions that lead to excessive losses.
Mastering these two aspects of loss management in Forex will ensure you preserve most of your capital and avoid wasting your capital.
4. Diversify your trading strategy
You will increase your chances of making a profitable trade and minimize your losses on a bad one by trading across different currency pairs.
This means dividing your capital over several currency pairs in different trades to benefit from price movements across the forex market.
It's the best way to ensure you profit from some of your trades while minimizing your losses.
5. Regularly adjust leverage
You must keep yourself informed about current market conditions to make the right decisions when using leverage in Forex.
This will involve keeping abreast of financial news concerning factors that affect forex market trade, such as interest rates, political stability, capital markets, and economic performance.
It will guide you on the leverage ratio to choose when placing a trade, where to place your stop losses, and which currencies to trade.
Conclusion
Leverage in Forex is a tool that can enable you to increase your profits significantly when trading currency.
It allows you to control a larger trading position than you could with only your capital.
However, you must remember that this is only a means of borrowing additional capital from your broker to increase your profits.
If you make the wrong trading decisions, you could lose your margin account/capital and part of your leverage, leading to debt.
Therefore, use the information in this article to understand how leverage works and how to use it properly to minimize your losses. It will make you a wise and profitable trader.
By : Lilian Aciro Kariuki
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