The Importance of Leverage

The Importance of Leverage19.04.2016


In Forex trading, there is usually used the leverage of 100: 1 or higher. At the same time, when the broker’s option includes leverage of 100: 1, it does not mean that it should be used at full level. A Forex trader with ingenuity will use of such an intriguing proposal only if the associated risks are clearly calculated and he will get significant benefits from it. In this article you can get acquainted with the technique of using leverage without any problems and make profits.

What is Margin and Leverage?

When a trader takes capital from a dealer or a broker in order to purchase a foreign currency or securities, this phenomenon is known as "buying on margin". As a rule the trader makes a deposit, introducing a certain amount on the broker’s account. After that, the trader’s money is used by the broker as collateral, which gives the trader the ability to conduct trades, the size of which exceeds his deposited amount by more times.

When operating with the leverage, buy/sell orders actually are executed with other people's money. For example, if the broker offers a maximum leverage of 20: 1, the trader can take a loan, the amount of which is higher by 20 times than trader’s investment. Thus, if a contract costs $10 000 and the broker provides the leverage of 20: 1, the trader will need only $500 of personal funds. In case the price of the contract goes up to the level of $11 000, then the net profit will reach $1000. The contract provided an income of 10%, yet the return for the trader is 200%.

Since Forex is the largest and most liquid financial market in the world, and the opening and closing of positions can be executed quite easily, the use of leverage is very popular. This situation gives traders the opportunity to keep under control the volume of losses. Considering these conveniences, Forex brokers have the opportunity to make their clients benefit from high leverages.

Forex market versus securities and futures

The leverage in Forex is several times greater than in other markets. If, for example, when it comes to stock trading, the amount of borrowed capital exceeds the amount of personal funds twice. When working with the futures, the maximum leverage can reach 20: 1. Finally, when we considering the Forex market, the leverage can reach 400: 1, or even 500: 1. This is a significant amount, so the broker and market maker (the market participant with the quotes) would request the signing of an agreement according to which there are specified the special conditions of closing a losing position. Because the risk is great for both the trader and the market maker, as a rule in the agreement there is stipulated that the position is closed automatically if the loss rate is 75% of the volume of margin or the deposit. In order to avoid forcing the trader to recharge his account after a negative balance and protect the broker, automatic closing of the position takes place when the loss threatens to be larger than the amount on the trader’s account. Therefore, the trader should be careful and study the terms and conditions of the broker.

What are the risks of a maximum leverage?

Typically the available margin is not used entirely. Leverage is used only in those cases when the trader is confident that the position will be a winning one. For example, the trader always needs a clear plan as to at what point the position should be closed if the market suddenly returns in the opposite direction. Once the value of each pip is determined, there is the possibility to calculate the amount of potential losses in the situation when the price touches the stop-loss. The figure should not be more than 3% of the used capital. When leverage is too high, and it turns out that the potential loss could amount, for example, 30% of the capital involved in trading operations, the amount of leverage should be reduced by so much that the expected loss would be no more than 3%. However, every trader should know his level of risk, so the 3% is not an absolute.

In addition, the higher the capital, the safer is the use of leverage. Leverage allows can help you easily make money, but the loss risk is also higher. To avoid the position being automatically eliminated in case of unexpected price jumps, the trader must keep enough money.

How to determine the amount of borrowed capital?

Consider a situation where the sum on the trading account is $10 000, and the trader has the intention to trade the USD/JPY pair with 10 mini lots. The currency pair movement at 1 pip using a mini account will cost $1. If the trade involves 10 mini lots, 1 pip it will cost $10. Trading with 100 mini lots will cost $100 for each 1 pips change. Thus, if the stop-loss works at a distance of 30 pips from the strike price, the loss could reach 30 UCD for each of the mini-lots: that is, $300 with 10 mini lots and $3000 with 100 mini lots. Therefore, in case a trader has $10 000 with a maximum risk of 3% for each trade, then it makes sense to lend only 30 mini-lots.

Conclusion

Trading in the Forex market gives you great opportunities that can grow by using leverage. At the same time, when using the leverage, the trader must clearly understand how to manage risks and set a clear stop-loss order. Also, the trader must have discipline and follow the rules. It is recommended to use open a demo account for the beginning. The simulation of leverage is also available for demo accounts with virtual money. It is a great practice that every beginner should try. Once you develop some skills, start with a moderate leverage and open a real account. 

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