One of the forex market features is that it offers high leverage compared to other financial assets markets. That’s why most of the traders find trading forex attractive. However, some traders have just heard the word “ Leverage,” and few know the definition and how it works.
The leverage relies on the trading conditions offered by a particular forex broker, and its size is not fixed at all the companies. This article will explore the usefulness of using borrowed capital for trading.
What Is Leverage?
Leverage enables traders to borrow the capital needed to invest in something. Money is usually taken from the broker in forex. It gives the potential to traders to trade much bigger volumes than he would, using only his own limited amount of trading money.
Let’s understand the concept of leverage with the help of an example when the investor wants to borrow money to invest in a stock. Let’s suppose, without leverage, you have $10000, and the value of ACME’s stock is $100. With $10000, you can buy 100 shares. If the stock value rises to $200, the maximum earning will be $10000.
However, if you borrow another $10000 from the bank and use it to buy stock, you can now purchase 200 shares. When the stock doubles, the total money you will earn is $40000. When you return the borrowed money to the bank, your net profit will be $20000 minus the bank interest.
The leverage is very beneficial for traders and investors when it works. But if it fails, it can bring massive losses. From the above example, it is clear that if the stock fell to zero, the investor would face a personal loss of $10000 and also the borrowed $10000 of the bank.
Leverage In Forex trading
The concept of leverage in the forex works in a similar way to that of borrowing money to purchase a stock. The online brokers increase their customers’ virtual credit, known as leverage. The virtual credit is added to the deposit of the customer.
The investors take advantage of leverage to increase their profit from forex trading. The forex provides the highest leverage available to investors. The brokers offer leverage that is a fund to investors.
The leverage is high up to 100:1 in the foreign exchange markets. It means that if you have $1000 in your account, you can trade up to $100000. Many traders believe that taking high leverage is a function of risk. However, proper risk management can lead to a successful trade.
The thing here to notice is that if you take a 100 times leverage, then even a tiny fluctuation in prices can translate into massive profit or loss. In simple words, the leverage magnifies your loss or gain in the forex market.
The leverage can give an advantage in many ways. First, it enables the traders to maximize their profits per trade. Second, a trader with a limited amount of money uses the leverage to invest in expensive assets like Bitcoin, gold, and other precious metals.
It would not be feasible if a trader trades with a $1000 account to invest in gold without leverage. The leverage size plays a vital role in deciding the success of the trade. If the trade goes well, the highly leveraged trader can profit more than a trader with low leverage.
Managing Leverage Risk
With a high leverage ratio, one can make more profit when a trade goes right. On the other hand, if the asset goes in the opposite direction, a trader with high leverage faces a massive loss than one with low leverage.
Most beginners often use high leverages and lose all the money instead of profit. It is not always the best action. In contrast, professional traders understand the threats of being overleveraged. They know that the secret of a successful trade is to reduce the risk and make a small profit.
The purpose of putting a protective stop-loss is to limit the losses in an unfavorable market by exiting out of the trade. The technique helps specify the amount you are willing to risk on the trade.
Take- Profit Orders
Take profit order is an order placed by the trader to be executed at the target price once the market reaches that specific price. This technique is also necessary because we know that the forex market is volatile, and anything wrong can happen that will not be in favor of traders.
The Bottom Line
Now we can say that leverage is like a double-edged sword. It allows the traders to earn a handsome amount of money in the forex market with a bit of initial capital. At the same time, if the trade goes in the opposite direction, it can also wash the trader’s account.
It is recommended that new traders focus on learning how the market works and use less leverage at the start.