September 6, 2022
Understanding leverage trading
What is leverage in forex? Leverage trading is a way to increase your exposure to market forces when you deal in foreign currency pairs. The forex market works according to laws of risk and reward — the greater the risk, the greater the potential reward. Therefore, the higher the leverage rate, the higher the potential return. However, this also increases the potential loss.
When you leverage a forex trade, you essentially borrow capital to supplement your money. Forex currency pairs move in pips — pips in forex are minimal price movements, so un-leveraged positions can only result in small profits and losses. By borrowing additional capital for leverage, you increase how much each pip movement is worth.
For example, if you trade with a leverage of 1:10, you are borrowing $10 for every $1 you put forward, and each pip is worth 10x the amount it would be without leverage. You will still need to pay this $10 back once you close your trade, which will be taken out of the profits of a successful position. You’ll need to pay this amount back if your position fails. This is why traders must be cautious and ensure they take the time to learn forex techniques before extending the leverage on their positions.
Calculating the leverage ratio
Leverage is generally represented as a ratio — for example, 1:10. The number on the left of the ratio represents the money you will put forward from your capital. In contrast, the number on the right represents the proportion you will borrow. With a 1:10 trade, you can use $100 of your own money to control a position of $1,000. With a 1:100 trade, this $100 will allow you to control a position with $10,000.
It’s important not to get carried away with leverage trading. Stick to your strategy, and only choose a leverage ratio you feel comfortable with. Don’t be tempted to push the boundaries, and stick to manageable levels of risk.
How to trade with leverage
The key benefit of forex leveraging is the profit potential, but you need a strong strategy if you are to stand a chance of realising this potential. This means understanding your risk tolerance and how much you are willing to borrow on your trade. Next, you’ll need to select a currency pair that best suits your strategy and choose a leverage ratio that aligns with your targets. Once these preliminary steps are complete, you can start to trade with leverage.
- Put protective measures in place
Before opening your forex position, you need to have some protective measures. These tools will help you maintain a sustainable approach to trading and ensure that your position remains within strict parameters. The main tools you will use take profit and stop loss, and you may use these with other forex trading techniques such as FX futures.
Take profit will automatically close the trade once a certain profit level is reached. With forex trading, mainly leverage trading, you are not simply trying to achieve the maximum level of return from each position. Instead, you want to ensure that your profits remain within your broader strategy. This tool helps ensure your profits don’t reach unsustainable levels and you stay on track for long-term growth.
Stop loss works the same way as taking profit but in the opposite direction. This tool enables you to set a loss limit. If your position struggles and falls to this limit, it will automatically be closed, and you will absorb the losses. The tool ensures that losses do not become unmanageable and helps you keep within the initial strategy’s limits.
Once you have chosen your leverage ratio and set your take profit and stop loss tools, you can open your position based on the current spot trading price. Open a buying position if you believe the currency pair’s value will increase, or open a selling position if you think it will fall in value. You should have a strategy for how long you expect to keep the position open.
When you reach your predetermined endpoint for the position, you can close it. This means the position is no longer exposed to market forces, and you will take any profits and absorb any losses incurred while it remains open. You now need to pay back the capital you leveraged on the position, whether you made a profit or not.
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FAQs
What is a good leverage in forex?
It’s difficult to say what is a good level of leverage in forex simply because this is a personal choice for individual traders. A good rule of thumb for traders is to start small and work exclusively with manageable leverage levels. While increasing your leverage allows you to achieve greater profits, it also increases your exposure to risks and losses.
If you are new to trading with leverage, you should use 10:1 leverage as an absolute maximum. This means you put $1 of your capital forward and use leverage to borrow $10. Consider using lower leverage when you are starting or unsure, but never exceed this level.
What is 1 to 500 leverage?
1 to 500, commonly represented as 500:1, is a very high leverage ratio. In this example, you borrow $500 for every $1 you put forward from your capital reserves. While this is great if your trade is successful, as you are essentially multiplying your profits by 500, it exposes you to a very high level of risk. Even if you opened trade with only $10, you would need to borrow $5,000 to use as leverage, and this $5,000 will need to be paid back whether the trade is successful or not. This means if your trade fails, you could find yourself in a significant amount of debt.
This rate of 1 to 500 is typically the maximum level of forex leverage traders are permitted to use. Most traders will not open positions with this sort of leverage.
Can I use leverage in forex as a beginner?
Anyone can use leverage when they trade forex. However, it’s essential to understand that forex significantly increases your trade risk. As noted above, beginner traders should keep their rate of leverage low and manageable, limiting their exposure while they get used to this trading technique.
Using a demo account is even better for beginners wondering how to trade forex with leverage. With a demo account, you can practice using leverage just like an actual trade, except there is no risk because you are neither putting forward any money nor borrowing any. You can’t make a profit from a demo account, but you can learn valuable techniques that will help you further down the line.
Is it possible to trade forex without leverage?
Yes, it is possible to trade forex without leverage. You can put forward your own money without borrowing or leveraging any additional capital. This reduces your risk exposure but also reduces your exposure to profits. Traders who do not use leverage will have to make massive amounts of successful trades or put forward a high level of capital before they start to make significant profits.
With this in mind, most traders use little leverage when they trade. As they get more accustomed to using this, they can gradually increase their risk profile to increase profit potential. Of course, there are no guarantees, and even experienced traders can lose money when leveraging. Other forex strategies, such as OTC derivatives like FX forwards, do not always require leverage, although traders do have the choice of opening a structured leveraged forward contract.
How do I reduce risk when trading forex with leverage?
It is possible to manage and reduce risk while leverage trading. The most effective way to reduce risk is to keep the leverage ratio low. If you are leveraging at 5:1, you stand to lose considerably less money on a failed position than if you were leveraging at 20:1. Traders are always looking for the sweet spot of optimal risk exposure without trading in an irresponsible and unsustainable fashion.
Another way to reduce risk is to grow your experience slowly over time. Get used to trading on a demo account and then practice leverage trading with live positions, using small amounts of leverage at first as you develop your understanding. This helps to foster a sustainable approach to this trading strategy.
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