This article looks at leverage as it is used on the FX rates market.
In order to be an effective trader on the foreign exchange market you must have an understanding of all aspects of forex trading. One of these aspects is that of leverage. This article will provide information on what leverage is and how it can affect you as a trader.
What is leverage?
Leverage is available from forex brokers, and can be viewed as a loan from the forex broker. This ‘loan’ allows a trader to execute large trades using only a small amount of trading capital. Forex brokers offer leverage as a means of making the trading market more accessible to the retail trader. It is only larger FX rates traders that have the ability to begin trading with premium accounts. This allows the smaller trader to make substantial profits with their mini lot positions.
The amount of leverage will differ from brokerage to brokerage making it important to do research before choosing a forex broker. Furthermore, the different accounts present with different levels of leverage. The most common amount for a standard account is 100:1, whereas mini accounts have an average leverage level of 200:1.
What are the drawbacks of leverage?
While leverage can be beneficial to a trader, there are also disadvantages to using leverage. The use of leverage raises the risk of a trade which can lead to either substantial profits or detrimental losses dependent on the market movement. For example, if you make a trade using a mini lot of $10,000 each pip would have a value of $1. A 5 pip movement will see you using $50 and making a 10% profit, if the trade is beneficial. However, if you lose 5 pips you will lose 10% capital just as quickly.
Leverage can be very damaging if used incorrectly. This is why you must be cautious when using it and consider the market conditions before trading with leverage. The majority of brokers will offer heavy leverage, but this does not mean you are obliged to use it.
Using leverage as an FX rates tool
As is mentioned, leverage can both advantageous and disadvantageous dependent on the market movements. However, to make a worthwhile profit on the forex market you may need to use leverage. Forex brokers will offer particular amounts to traders, but this does not mean you need to utilise all of the leverage. In fact, there are ways to use leverage sparingly and still gain satisfactory profits.
A good time to utilise leverage is when adding amounts to a profiting trade. If you hold a trade that has progressed favourably, and are considering adding to it, then you should look at using leverage. This will raise the chance of overall profits and is known as leveraging your profits.
Using extreme leverage when trading
Although leverage can be used for positive means, you must be wary of the leverage levels offered. The majority of forex brokers will offer levels of 100:1 and 200:1, but there are those who will offer extreme leverage of 400:1. It is advised that you avoid these brokers as traders using 400:1 leverage have been known to experience more losses than profits. This is due to one having to trade having an average pip size of $120,000 which can lead to account depletion within a few pip movements.