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Forex Leverage: a Friend and a Foe

One of the things that make Forex trading more appealing is that in Forex you can trade with higher leverage, unlike other financial markets. In Forex trading, you don’t need to invest all of your money to place larger orders. Instead, you can use the leverage provided by the brokers.

Leverage seems so attractive to many new traders that they usually go for the highest leverage opportunity the market has to offer as a way of minimizing their expenditure and still earn some profits. However, it is better to familiarize yourself with what leverage is and how it works before jumping into the broker’s leverage pool.

What is Leverage in Forex?

Many brokers nowadays facilitate trading for their customers by offering trade sizes much larger than their actual capital. In essence, the traders borrow money from the brokers in order to participate in larger-size trades. In this way, the traders are enabled to place orders as big as 100,000 units of currency with only 1,000 units of equity in their account. This is called Leverage.

To be able to use leverage, traders must have a certain amount of money available in their account as a security deposit. This is called Margin. The amount of money needed to provide as a margin depends on the rate of selected leverage.

Later, when the trades are successful, the traders will get their profits and the borrowed money, or the leveraged amount, will return to the broker. However, when the trades go south and result in losses, the amount of loss will be taken from the account margin, and the borrowed money will return to the broker intact.

How does leverage work in Forex trading?

Leverage works as a loan from the broker to the traders to control larger trade sizes and increase their returns. Later when the trade is closed, the borrowed money should return to the broker in full amount.

So, let’s say trader A has only $1,000 in his account and wants to trade with the EUR/USD currency pair. He can only place one micro lot consisting of 1,000 units of the currency given his account balance, but he wants to place one standard lot instead, or 100,000 units. Therefore, he needs an additional $99,000 to be able to start trading. This additional money can be obtained using leverage.

The leverage that trader A needs to start trading is counted as below:
Forex leverage
Trader A then starts trading one standard lot using 1:100 leverage with his margin of $1,000. After the trade is closed, trader A gains 0.0010 in profits or 10 pips.
Forex leverage profit
The acquired $100 profit belongs to trader A and goes directly into his trading account. Then, the leveraged amount returns to the broker in full. Now, trader A holds an equity of $1,100.

On the contrary, when trader A loses 10 pips after closing the trade, the $100 he lost will be taken from his account. The broker still receives his loaned amount in full. Consequently, trader A now holds an equity of $ 900.

There are different levels of leverage offered by forex brokers to choose from according to your desired trade quantity, level or needs. For example, if you have $1,000 capital in your account and use it as a margin, depending on the leverage amount the reach of your trading capital will be as follows:
forex leverage levels

The Advantages of Trading with Leverage

Leveraged trading provides benefits for traders such as:

1. Increasing Potential Profit

Using the same amount of capital with the help of leverage will result in higher profits.

2. Maximizing Capital Efficiency

With leveraged trading, you can earn more profits by spending less time. In the above example, it takes 50 profitable trades to get you a $5 profit without the leverage. Whereas, leveraged trading enables you to get a $5 profit in just one trade. Your $1,000 capital is used in its maximum efficiency.

The Disadvantages of Trading with Leverage

Leveraged trading indeed enables traders to increase their market coverage, exceeding their actual investment so they can get more profits. Nevertheless, be careful in using leverage because it may backfire.

Increasing trading risk

Trading your capital via leverage increases your exposure to greater risks; thus, it magnifies both your potential profits and losses at the same time.

According to the example above, as your pip value increases with the leverage, your capital will be exposed to greater risks or losses. One loss of 10 pips in a trade means $1 without the leverage, but with the leverage losing 10 pips in a trade means you lose $50. Imagine if this happens 10 times. Without the leverage, you only lose $10, but with the leverage, you lose $500. In this case, your trading account will dry up in no time.

Should Traders Avoid Leverage?

Not really, you don’t need to be afraid of leverage once you understand how to manage it.

You can take advantage of leverage by choosing smaller sizes for each trade and avoid significant losses by proper risk management. So, you need to decide the best leverage for your capital. The bottom line is, leverage is very flexible and customizable, so you are free to manage it according to your trading needs.