What does leverage mean in Forex?
“What is forex leverage?” might be one of the questions you may have wondered about, which is why we have compiled this beginner’s guide. Here we will discuss all the important aspects related to forex leverage. You will learn how to use leverage in forex trading and many other important things. So, without any further delays, let’s get started.
What is leverage in Forex trading?
Using borrowed money (also called capital) to invest in stocks, security or currency is known as forex leverage. Forex trading and leverage go hand in hand, and they are intertwined in more than one way. By borrowing money from a lender, a trader can invest much larger sums of money than he actually possesses, thus increasing his profit margins. For instance, you can have $1,000 in your account, and trade on $100,000 if your leverage is 100:1. Leverage can reach 500:1 on some online platforms, while the typical leverage in equities trading is 2:1, and the futures market – 15:1.
However, like most things in life, leverage also comes at a cost. To put it simply, leverage is a double-edged sword, which means it can also magnify your losses just like your profits. Therefore, it is very important for you to understand how to use leverage and how to maximize your profits while keeping the risk of loss at a minimum using leverage.
Forex trading leverage explained
With over 5 trillion USD traded every day in different markets around the world, Forex is the largest market in the world. In forex trading, investors will purchase a particular currency in the hopes of selling it later when the prices are higher. The selling and buying prices of all the currencies are available with the broker and they will quote the price based on the trade you intend to make. For example, an investor buys the Euro versus the USD (EUR/USD) in the hopes that the exchange rate will rise. Assume the trader buys the EUR/USD pair when the price is $1.10. He will sell his position a few hours later when the price has moved up. This difference in the buying and selling will represent the trader’s profit or loss.
Let’s see how leverage works in forex. The key point is that it is used to amplify the profits, or may increase the losses in the worst-case scenario. In the forex market, the amount of leverage offered is one of the highest among all the markets in the world. In simple terms, leverage is a loan that the brokers give to traders. If you are a new trader, the brokers might put some limitations and conditions on the amount of leverage you can get. Once you have become an established trader, these restrictions will slowly melt away. Usually, traders tailor their trades in such a manner that it fits perfectly with the amount of leverage they have.
Depending on the trade size, the initial margin required by each broker may vary. For instance, if an investor buys $200,000 worth of USD/EUR, they might be required to hold at least $2000 in the account as a margin. In other terms, 1% or ($2000/ $200,000) might be the margin requirement. The purpose of leverage ratio is to show the trade size magnification as a result of margin held by the broker.
Trade size and Forex leverage
Margin requirements differ for small and large trade sizes. The standard trading is done usually on 100,000 units of a currency, so for a trade of this size, the leverage margin might be 100:1 or 50:1. For positions of $50,000 or lower, a leverage margin of 200:1 might also be available. Many brokers also allow traders to execute small trades between $10,000 and $50,000 while keeping the margin low. However, if the account is totally new and there is no trade history, a 200:1 leverage may not be offered.
For up to $50,000 trades, it is very common for brokers to allow up to 50:1 leverage ratio. A 50:1 leverage trade means that the margin requirement is 1/50= 2%, which means you have to keep $1000 as a collateral for a $50,000 trade. One important thing to keep in mind here is that leverage margin requirements might change depending on the currency and broker used. For emerging currencies, some brokers might require up to a 10-15% collateral.
Leverage and its risks
Using leverage, a smart investor can earn some handsome profits, but leverage also comes with some significant risk, especially if you are not careful. If the currency pair that you chose to trade moves in the opposite direction from what you had anticipated, leverage can greatly amplify your losses. To limit the damage traders usually use stop-loss orders that request to sell the position automatically if and when the currency has dipped below a certain level. Leverage is something that can greatly benefit a serious trader, but it should only be used once you have complete knowledge of how it works and the risks associated with it.
Can I trade Forex without leverage?
If you might have wondered whether you can trade without leverage, then the simple answer is yes, However, trading carefully with leverage has some added benefits and can really be a powerful tool. With good leverage margins, you can take several positions and increase your potential profit.