Leverage in Forex is considered a high-risk form of trading. However, this is just how an amateur investor views leverage. This tool can be very profitable in a short time. So, what is leverage in Forex? How does leverage work? Let’s learn about the problems of leverage through the following article.
What is leverage in Forex?
In trading and investing, the term leverage is used when an investor uses a small amount of money to control a more significant amount.
This is the ratio of money customers who convert to the allowed volume. The size of leverage in Forex often exceeds the capital invested by several times to several hundred times.
To use leverage, you need to register your account. This account is called a margin account. After successfully completing the registration, the broker will lend you a large amount of money to buy the property. Leverage in Forex is expressed as a ratio such as 1:2. 1:5, 1:100, 1:500, 1:1000,…
For example: when you hold $100 in your margin account, you can make transactions with different values such as $200, $500, $1000, etc.
In particular, leverage is directly related to the concept of margin trading in financial investments. Therefore, traders need to understand the idea and how to calculate the margin correctly. According to the actual survey, the higher the leverage, the lower the margin.
Example: You need to open an exchange worth $1000. At that time, the minimum deposit or margin level will be $200. Therefore, the broker will use $800 to lend you.
How does leverage work in Forex?
Once you understand what leverage is in Forex, you can continue to learn how it works. Below, we will explain how the tool works by comparing leveraged and non-leveraged trading.
Let’s say: Your margin account is currently $200. The leverage of the account is 1:500. Then:
Case 1: Trade without leverage
Let’s say you’re ordering 0.2 lots of USD/CAD for 20,000 USD. The minimum deposit is now $20,000. Your account is currently $2000. Therefore, the transaction is not executed.
You will then reduce the trading volume to 0.01 lots per 1000 USD. The corresponding minimum deposit is $1000.
- If the price goes up and your trade wins by 100 pips, the order profit will be equal to the order volume multiplied by the number of winning pips and the pip value.
- Specifically: 1000 x 100 x (0.0001/1.13200) = $8.83
- Where: 1.13200 is the exchange rate of the USD/CAD pair at the time of closing the order.
- Conversely, if the price drops and your trade loses 30 pips, the amount of the loss is equal to the order volume multiplied by the number of pips lost and the pip value.
- Specifically: 1000 x 30 x (0.0001/1.11900) = 3.36 USD
- Where: 1.11900 is the USD/CAD exchange rate at the time of order closing.
Case 2: Leveraged Trading
The exact deposit amount is $1000, but you can use 1:100 leverage. So, the successful trading volume will now be one lot.
- If the price increases and the trade wins 100 pips, the profit of the order will be: 100,000 x 100 x (0.0001 / 1.13200) = $ 883.
- If the price drops and the trade loses 30 pips, the amount of the order loss is 100,000 x 30 x (0.0001/1.11900) = $336.
Compared to not using leverage, it is allowed to trade with an order worth 100 times. Same ratio 1:100 and deposit of 1000$, but maximized profit up to 100x. At the same time, if the trade fails, the amount of the loss is also increased by 100 times. Therefore, leverage strategy in Forex is always considered a double-edged sword.
How much leverage should be used in trading?
Not only do they wonder what leverage is in Forex, but traders often ask themselves the question: “Should I use leverage or not.” In fact, given the nature of the forex trading market, researchers will not give a specific answer. Instead, they will tell you “how much leverage should be used.”
If you are a new trader with limited investment capital, you should use a low leverage ratio. Perhaps, this is a way to help you experiment and summarize the best investment strategies. After gradually familiarizing yourself with the market, you can execute great trading strategies without fear of risk.
According to the experience of brokers, new investors should choose a leverage ratio of no more than 1:100. During the trading process, you can gradually increase your leverage ratio accordingly.
Professional traders always aim for high profits. Therefore, they will choose a higher level of leverage to make a decent profit.
Pros and cons of leverage
What are the strengths and weaknesses of the leverage strategy in Forex? In fact, this is what many investors are interested in. In particular, new traders need to understand the nature of this tool.
Here are the exceptional advantages of leverage in Forex:
- Optimize profits on small capital: You can see that this is the most significant advantage of leverage. With only a small amount of initial money, investors can make transactions with a much larger value. That is, instead of paying the total amount for the trading period, you only have to pay a small portion. This tool is very suitable for investors with little capital and inexperience.
- Low: Usually, you need to have at least 1000 USD to participate in the Forex market. However, the leverage tool only requires traders to own capital as low as 1 USD. Namely, the cost of leveraged trading in Forex is low.
As mentioned, leverage in Forex is like a double-edged sword. In addition to the considerable advantages, it has a rather serious disadvantage. The element of risk and loss amplification/as much as leverage helps increase profits, will amplify losses when trades fail. Therefore, you need to consider very carefully when choosing the leverage ratio.
Right now, you have learned what leverage is in Forex. In addition, there is some information related to leveraged instruments. Please refer and carefully study the trading strategy to achieve high efficiency.