What is leverage in Forex trading? What are the advantages of leverage? Forex markets have many advantages, such as low spreads, diverse range of tradable instruments, 24/5 access to capital markets. But if you ask me, one of the biggest advantages of Forex is leverage. As far as I can see many Forex traders (experienced or new) are still confused about the functioning of leverage. So, I hope this article will help you to find all the answers in your head.
The leverage in forex markets allows you to open higher volume of trades with relatively low amount of capital. But as I wrote before, main factor that will affect your profits and losses is the lot size. However, if you are a new trader I still won’t recommend you to use very high leverage before you gain some experience. Because like I said, with higher leverage you can execute larger trades.
Basically, you can boost your account with the help of leverage. Leverage ratio can be change from broker to broker. You can find brokers that offer you leverage ratios from 1:100 to 1:1000. For stocks, commodities, cryptocurrencies and futures, leverage can be lower than other instruments. This ratio changes depending on which broker you are working with and maximum leverage offered by brokers varies based on the regulation.
Let’s say your broker offers a maximum leverage of 1:100. You normally need $100.000 to open a 1 lot trade, but you can open that trade with only $1.000 margin thanks to the leverage ($100.000/100=$1.000). This means with $1.000 deposit, you can invest as much as $100.000 with the help of leverage.
If you are using 1:200 leverage, then you will need just $500 for that ($100.000 / 200 = $500). As you can see as the leverage ratio goes higher, the amount of capital you need for your trades goes lower.
You want to sell EURUSD and assume that EURUSD exchange rate is 1.20. When you execute 1 lot of EURUSD order you normally need $120.000 margin (100.000 x 1.20 = $120.000). With the help of 1:100 leverage, you will need $1.200 margin to execute that trade.
When used correctly, high leverage is a big advantage but that requires successful and disciplined risk management. Otherwise you can lose all of your investment very quickly because of the high leverage.
I will give you an example. Let’s say you bought 1.0 standard lot (100.000 units) of EURUSD at the price of 1.20 which is worth to $120.000. You have $2500 in your trading account and the forex broker locked $1200 margin for that trade if your account uses 1:100 leverage.
If the price of EURUSD goes down by only 250 pips to 1.1750, you would lose all of your capital because you invested 100.000 units. Do the simple math and 100.000 unit of EURUSD at the price of 1.1750 equals to $117.500.
Therefore, leverage can be both your enemy and friend depending on how you understand and use it appropriately. Also, forex Brokers that offer you high leverage can be tricky. Many unregulated forex brokers will try to attract traders with very high leverage, so I advise you to be careful about that. Make sure that the forex broker you choose is regulated and reliable.