Think of forex leverage as a bank loan with interest. The idea sounds fantastic, until you learn the conditions and requirements! In trading, leverage allows you to gain access to a huge investment funds in currencies with a small initial deposit amount. For example, leverage of 1:200 makes rather miserable $100 turn into an attractive $100x200=$20,000 of tradable currency.
While the trading profits are multiplied and expanded, so are the possible losses. So before you get all excited about 4 zero sums you can now trade, it is important to understand that taking very high leverage increases your chances to make lots of money, but it also increases the possibility of clearing your account before you blink.
What is Forex?
Foreign currency exchange (aka forex) is the market where currencies can be exchanged for one another. Being the largest, most liquid financial market in the world, currency trading is exchanged online via computer networks between traders everywhere. The market is open 24 hours, 5 days a week and offers frequent profit opportunities throughout the week.
How is Leverage Used?
The most common leverage you can see offered by most brokers are from 50:1 to 400:1. There are, of course, exceptions with brokers going overboard offering crazy leverage such as 888:1 and higher but just because there is some nutcase running around without clothes on in winter in Canada, doesn’t mean you need to do the same. You know what I mean?!
So for example with EUR/USD pair quoted at 1.3604 in order to make a transaction of 100,000 of this specific currency pair, with the leverage of 100:1 the trader only needs to have $1,360.40 margin deposit in order to trade $136,040 amount.
Exciting? Sure is! Risky? Definitely! But, first of all, without leverage, trading online for individuals like me and you would not be possible at all, and second, without climbing all the way to a top mountain, you won’t see a gorgeous view. With risk comes the sweet sound of the profits.
Why Leverage is needed in the first place?
As I have mentioned before, without leverage, none of us would be here right now trading our way to the riches. The incremental changes in currency exchange rate are calculated in 1/100 of a cent. This is what we call a PIP. Since currency prices can go up and down rapidly changing from few pips to hundreds pips a day, $10,000 worth of currency will only make you few dollars on a trade.
Would you risk $10,000 in order to profit or lose $20 or less? I didn’t think you would! So here is where the leverage creeps in with its attractive purpose. With the leverage of 100:1, instead of $10,000, you need to have $100. With a small deposit like $100, suddenly the profit of $20 sounds pretty good, making leverage very lucrative option for forex traders.
How to protect yourself from leverage dangers?
Leverage allows you to earn significant profits with small investment amount. It can also turn against you and wipe your account clean. To avoid the magnifying effect of the possible loss, forex traders use disciplined trading strategies such as stop and limit orders.