Why is Leverage so Important in Forex Trading?
Leverage is an integral tool in every forex trader’s arsenal.
Traders are attracted to the forex market due to its inherently low volatility and the ability to magnify that volatility as necessary using leverage.
Leverage is trading with borrowed capital, allowing a trader with a relatively small account balance to open up much larger positions than they would otherwise be able to.
For example, using leverage, a trader with just $1000 USD of capital could open up a $10 000 USD position and potentially generate 10 times as much profit if the market moves in their favour.
As the forex market generally moves less than 1% per day, leverage is essential to generating significant trading results.
Forex Leverage Explained
Forex Leverage Ratios
In the above example, our trader had $1000 USD and opened up a $10 000 USD position, 10 times the value of their capital. This means our trader used leverage of 1:10. Both their potential gains and losses would be magnified by 10.
Forex brokers generally offer a range of leverage options ranging from 1:1 to as much as 500:1. Yes, this means that if our trader used 1:500 leverage, they could open up a position equal to half a million dollars!
If this position were profitable, they would make a lot of money, but they could also lose their $1000 margin deposit very quickly too.
Margin is the collateral the trader deposits with the broker in order to secure the funding for their trade and this margin needs to be maintained while the trader has a leveraged position open.
If your margin drops too low, your broker will attempt to close out your position to protect you from losses exceeding your deposit.
Leverage Magnifies Gains and Losses
Nothing in life is free and this is especially true in trading.
Though leverage increases your profit potential, it also increases your potential losses in a linear fashion.
Let’s take a look at 1:500 leverage and the effect this kind of leverage could have on your small account.
Example 1: A Profitable Trade and a Doubled Account
Trader 1 uses a $1000 margin deposit to open up a $500 000 long position on AUD/USD.
AUDUSD moves up 0.5%.
As our trader used leverage of 1:500, that 0.5% gain in the Australian dollar is magnified by a factor of 500, generating an incredible 250% profit from a single trade.
Example 2: A Losing Trade and a Blown Account
Trader 2 uses a $1000 margin deposit to open up a $500 000 short position on AUD/USD.
AUD/USD moves up 0.2% – Yes, just a relatively minor move.
As our trader used leverage of 1:500, that 0.2% loss is magnified 500 times over and our trader loses their entire trading balance.
You can see from the above examples, though trading with such a large amount of leverage can lead to serious profits, it can just as easily wipe out your entire account balance with a relatively minor market move.
Responsible Use of Leverage in Forex
So how much leverage should our traders have used in the above examples?
Well that would depend on their individual risk tolerance and profit goals, but let’s continue with the above examples and assume both traders have a similar risk tolerance.
This is that they’re both happy to risk losing 1% on their trades and would get out of the market if it moved 0.2% against them.
Example 1: A Profitable Trade With Responsible Use of Forex Leverage
Trader 3 wants to open up a long position in AUDUSD. They are managing their risk responsibly and have looked at the potential downside in the market and how much capital they are willing to risk on this trade. As they will exit the position if the market moves against them by 0.2% and they are happy to risk 1% of their capital on this trade, they can use 1:5 leverage.
Trader 3 uses a $1000 margin deposit to open up a $5000 long position on AUDUSD.
AUDUSD moves up 0.5%.
As our trader used leverage of 1:5, that 0.5% gain in the Australian dollar is magnified by a factor of 5, generating a return of 2.5%. This is not a life changing return in any way, but what would happen if our trader executed similar trade every day for a year?
That’s right, it’s in these consistent low risk gains that a professional career as a forex trader can be carved out.
Example 2: A Losing Trade With Responsible Use of Forex Leverage
Trader 4 wants to open up a short position in AUDUSD. They think that if AUDUSD rises by 0.2%, it will likely rise further and they will exit their short position. As they will exit the position if the market rises by 0.2% and they are happy to risk 1% of their trading capital, they will also execute a trade with 1:5 leverage.
Trader 4, therefore, uses a $1000 margin deposit to open up a $5000 short position on AUDUSD.
AUDUSD moves up 0.2%.
As our trader used leverage of 1:5 to open up a short position on AUDUSD, the 0.2% rise in the Australian dollar translates to a loss of 1% of their account balance. The trader accepts the loss of 1% and moves on to find the next opportunity.
The Tortoise and the Hare
The differences between the above two groups of traders should be immediately clear.
The first two traders are essentially gambling, though the first trader using 1:500 leverage wins a few trades, he doesn’t last the week, eventually hitting a loss and losing all his profits as well as his initial deposit.
The second trader didn’t even last a few hours…
When it comes to traders 3 and 4 though, they are still here years on, generating small losses and slightly larger profits, day in and day out, generating a full time income from their forex trading.
It’s like the old story of the tortoise and the hare, sometimes the fastest way of achieving your goals is the slow and steady approach and this is especially true when it comes to leverage and forex trading.
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