Leverage in Forex
The concept of leverage is used by both investors and companies. Investors use leverage to significantly increase the returns that can be provided on an investment. They lever their investments by using various instruments that include options, futures and margin accounts. Companies can use leverage to finance their assets. In other words, instead of issuing stock to raise capital, companies can use debt financing to invest in business operations in an attempt to increase shareholder value. Leverage in general terms simply means borrowed funds. Leverage is widely used not just to acquire physical assets like real estate or automobiles, but also to trade financial assets such as equities and foreign exchange (“forex”).
The leverage in the margined account is collateralized by your initial margin (deposit), if the value of the trade (position) drops sufficiently, the broker will ask you to either put in more cash, or sell a portion of your position or even close your position. Margin rules may be regulated in some countries, but margin requirements and interest vary among broker/dealers so always check with the company you are dealing with to ensure you understand their policy. You must be wondering how a small investor can trade such large amounts of money (positions). The amount of leverage you use will depend on your broker and what you feel comfortable with. There was a time when it was difficult to find companies prepared to offer margined accounts but nowadays you can get leverage from a high as 1% with some brokers. This means you could control $100,000 with only $1,000.
To trade $100,000 of currency, with a margin of 1%, an investor will only have to deposit $1,000 into his or her margin account. The leverage provided on a trade like this is 100:1. Leverage of this size is significantly larger than the 2:1 leverage commonly provided on equities and the 15:1 leverage provided by the futures market. Although 100:1 leverage may seem extremely risky, the risk is significantly less when you consider that currency prices usually change by less than 1% during intraday trading. If currencies fluctuated as much as equities, brokers would not be able to provide as much leverage.
Let’s assume that you are an investor, and have an account with 5Stars Forex. 5Stars Forex provides you the maximum leverage of 1:100, which means that for every dollar you put up, you can trade $100 of a major currency. You put up $5,000 as margin, which is the collateral or equity in your trading account. This implies that you can put on a maximum of $500,000 ($5,000 x 100) in currency trading positions initially. This amount will obviously fluctuate depending on the profits or losses that you generate from trading. (we ignore commissions, interest and other charges in this examples.)
Tips When Using Leverage
While the prospect of generating big profits without putting down too much of your own money may be a tempting one, always keep in mind that an excessively high degree of leverage could result in you losing your shirt and much more. A few safety precautions used by professional traders may help mitigate the inherent risks of leveraged forex trading:
Cap Your Losses: If you hope to take big profits someday, you must first learn how to keep your losses small. Cap your losses to within manageable limits before they get out of hand and drastically erode your equity.
Use Strategic Stops: Strategic stops are of utmost importance in the around-the-clock forex market, where you can go to bed and wake up the next day to discover that your position has been adversely affected by a move of a couple hundred pips. Stops can be used not just to ensure that losses are capped, but also to protect profits.
Don’t Get In Over Your Head: Do not try to get out from a losing position by doubling down or averaging down on it. The biggest trading losses have occurred because a rogue trader stuck to his guns and kept adding to a losing position until it became so large, it had to be unwound at a catastrophic loss. The trader’s view may eventually have been right, but it was generally too late to redeem the situation. It's far better to cut your losses and keep your account alive to trade another day, than to be left hoping for an unlikely miracle that will reverse a huge loss.
Use Leverage Appropriate to Your Comfort Level: Using 50:1 leverage means that a 2% adverse move could wipe out all your equity or margin. If you are a relatively cautious investor or trader, use a lower level of leverage that you are comfortable with, perhaps 5:1 or 10:1.
While the high degree of leverage inherent in forex trading magnifies returns and risks, using a few safety precautions used by professional traders may help mitigate these risks.