When compared to other financial instruments, forex trading draws a lot of traders since you can typically acquire much larger leverage than you would with stocks. Although many traders have heard of the term “leverage,” few are familiar with what it means, how it operates, and how it can negatively affect their bottom line.
The idea of entering a deal using someone else’s money is equally applicable to currency markets. In this post, we’ll cover the advantages of borrowing money for trading as well as the potential drawbacks of using leverage in your forex trading strategy.
Leverage: What Is It?
In forex, leverage is similar to a “loan” that the broker extends to the trader so that the trader has access to more capital than what was initially placed. A ratio is used to illustrate it. Depending on the client’s knowledge and experience, FXTM may offer leverage levels of 1:50, 1:100, 1:200, and 1:500. Here’s an illustration of how leverage functions: Consider a trader who is using a leverage ratio of 1:100 and has a trading capital of €10,000. His trading money is multiplied by 100 in accordance with his leverage, giving him €1,000,000 (10 000 x 100) to work with in the market. He will practically double his capital if he chooses to purchase the EURUSD at 1.3055 and close his trade at 1.3155! ((1.3155 – 1.3055) x €1,000,000 = $10,000).
On the other side, this same trader will have lost roughly half of his capital if he purchases the EURUSD at 1.3055 but closes his position at 1.3005. ((1.3005 – 1.3055) x €1,000,000 = -$5,000). It’s crucial to keep in mind that while leverage might help you raise more money and provide you more chances to improve your earnings, it can also help you increase your losses. So be careful how you use leverage!
In Forex Trading, leverage
Leverage in the foreign currency markets is frequently as high as 100:1. This implies that you can trade up to $100,000 in value for every $1,000 in your account. Many traders think that since leverage is a function of risk, that is why forex market makers give such high leverage. They would not be offering the leverage unless they were confident that the account would be adequately managed and that the risk would also be highly controllable. Additionally, due to the size and liquidity of the spot cash forex markets, it is much simpler to enter and exit a trade at the desired level than it is in other less liquid markets.
Pips, the smallest change in currency price and a unit used in trading, are what we use to track currency changes. In reality, these changes only amount to a few cents. For instance, the exchange rate only changes by 1 cent when the GBP/USD currency pair goes from 1.9500 to 1.9600, or 100 pips.
Because of this, significant sums of money must be exchanged in order for small price changes to be converted into larger profits and then compounded by leverage. When dealing with a quantity like $100,000, slight fluctuations in the exchange rate can have a big impact on your profits or losses.
Risk of Using Too Much Real Leverage When Trading Forex
The problem with true leverage is that it can either increase your profits or decrease them by an equal amount. The risk you take on increases with the amount of leverage you apply to your capital. However, if a trader is not diligent, it may have an impact. It should be noted that this risk is not always tied to margin-based leverage.
Let’s use an example to demonstrate this idea. They both trade with a broker who requires a 1% margin deposit, and they each have a trading capital of US$10,000. Both of them think that USD/JPY is reaching a high and should decline in value after completing some study. They both short the USD/JPY at 120 as a result.