Understanding the concept of leverage may seem straightforward, but it is often misused and misinterpreted. It is important for beginner Forex traders to grasp the concept of leverage, understand how leverage can increase their risk in Forex trading, and learn how to use it responsibly.
What is Leverage?
Simply put, leverage is the use of a small amount of capital to access large trading opportunities through borrowed funds. In Forex trading, these borrowed funds typically come from a Forex broker.
Leverage in Forex allows traders to take larger positions than their actual capital would allow. Think of it as using a lever to move an object much heavier than you could handle by yourself.
Leverage is always expressed as a ratio. For example, a leverage ratio of 100:1 means that the necessary margin required to open and maintain a position is one-hundredth of the transaction size. So, with 100:1 leverage, a trader would need 1,000 USD to control a position size of 100,000 USD.
How to Use Leverage
It is crucial to approach using leverage with caution and a well-defined strategy.
Here are a few aspects to consider on how to use leverage:
- Solid foundation
Ensure you have a strong understanding of Forex market dynamics, risk management techniques, and trading strategies. - Start small
If you are new to leverage, begin with low leverage ratios to get comfortable with the risk involved. - Define your risk tolerance
Leverage can magnify losses significantly, so ensure you are comfortable with the potential downside before using it.
What Are the Risks?
While leverage magnifies potential profits, at the same time it amplifies risk in terms of potential losses to the same degree.
You can avoid the potentially negative impact of leverage by using risk-management tools provided by brokers. Other ways to manage risk when using leverage are to keep positions small and to limit the amount of capital for each position.
Sound risk management strategies are essential when trading on leverage.
Using Leverage Responsibly
Because of the potential risks involved, it is advisable to use leverage in a responsible manner, especially if you do not have a lot of experience with it. Here are some tips to assist you in using Forex leverage responsibly:
- Calculate the position size
Do not risk more than a small percentage of your total trading capital on a single trade, even with low leverage. - Use stop-loss orders
Most Forex traders use stop-loss orders to limit potential losses. A stop-loss order is an instruction the trader gives to the broker specifying the maximum loss that can be incurred on a position. Your positions will automatically close if the market moves against you, i.e. at a certain price level. - Maintain margin requirements
Ensure you maintain sufficient margin in your account to avoid margin calls from your broker. A margin call occurs when your account falls below the minimum required margin level, forcing you to either deposit more funds or close positions. - Monitor market volatility
Be cautious about using leverage during periods of high market volatility, as rapid price movements can exacerbate losses.
In Conclusion
Leverage can be used successfully and profitably with proper management. It can open a world of new possibilities, but it can also cause total loss if mismanaged or not used responsibly.
Leverage must be handled carefully. Once you know how to do this, you will be able to use it to your advantage. A great way to become familiar with using leverage is with a demo account that involves no risks and allows you to experiment with different levels of leverage. Most good brokers offer a free demo account.
