Leverage is one of the most important elements in forex trading or we can say that it is one of the primary reasons which allows plenty of trading by increasing your investments beyond your capabilities. However, along with the increased capabilities, it is also one of the most riskiest factors of the trading. So, before you even think of it, you must be aware of it in detail.
However, in this blog, we have discussed leverage in detail, pointing margins to profit till lost, with the only motive to clear down all your queries and pave you towards the best path of trading. Excited? Me too! Let’s start.
What is leverage?
Leverage is the investment made by borrowing funds to maximize the return on investment or to raise funds for the company.
In simple terms, the amount raised in the form of a loan by the broker is to open sources for trading positions which was far from the possibility of the initial investment. The value of the initial investment which is known as the margin account acts as the collateral value for the borrowed amount and hence allows you to trade and maximise the profit. However, it is important to note that every account has its individual margin requirement which is necessary to fulfill before using leverage.
For example, if your margin requirement is 1% of the leverage value i.e. $100,000. Then, you need to deposit $1,000 as a collateral value to open the position for $100,000. With this, you will be trading on the ratio of 100:1.
As leverage opens up the opportunity and allows you to trade for a larger amount, it also brings up the risk of profit and loss. So, it is necessary to amplify both profit and loss while you trade.
What is the margin?
The treaty facilitates when a trader has a trading account, which is primarily known as a margin account. And, the amount which is deposited by a trader in his account to unlock the opportunities of leverage is known as the margin.
The margin is termed as the collateral amount for the leveraged amount and hence allows the trader to borrow the amount from the forex broker accordingly. However, when leverage is closed, the margin funds are released and hence can be used for trading, especially the amount that faced the loss or at risk of losing the trade.
What is a leverage ratio?
Leverage where means borrowing the amount, leverage ratio terms the amount of money that can be borrowed relative to your investment amount.
For example, if you want to control a $100,000 position in the forex market and your broker offers a leverage of 10:1, then you need to invest $10,000 as a collateral amount and the remaining amount of $90,000 is raised through the broker.
So, how do you count the leverage ratio? Well, here’s a quick process or say a formula that can help you to calculate your leverage ratio to your investment.
- Leverage Ratio = Total Value of Position / Trader’s Own Investment
- An example, for every leverage ratio of 100:1 = Your traded value for $100,000 / Your initial investment amount will be $1,000.
Now, how do they decide profit or loss incurred? Well, that too explained. Here you go!
So, the profit or loss is decided as per the currency movement. If your currency pair moves in the trader’s favor it ensures you give a profit of $100,000 and similarly, if it moves against your favor, it might lead to a significant loss, potentially losing more than your initial investment.
Let me clear this, up with a quick example:
Suppose, you are investing $1,000 without leverage, and with the market factors and exchange rates, there has been an increase of 1% which will lead to a profit of $10, whereas if you are investing $1000 with a leverage of 10:1 for $100,000 and there is subsequent rise in the amount with 1% then, you will lead to incur a profit of $100.
However, if the profit rate tends to depreciate and leads to loss, you might also lose $100 from your value. So, leverage opens up the path to profitability but also opens the path to risk that goes hand-in-hand.
How much leverage should you use when forex trading?
As we know, leverage gives us the freedom to trade over a large amount leading us to incur a high profit, but we should also consider the significant amount of loss associated with it. So, before you decide the leverage amount for yourself, try considering these points, to subsequently lower the risk associated. Here are a few quick tips:
- Define the risk-bearing capability- The first step begins with defining the risk-bearing capability of yours. If you’re looking to play safe and want to leverage with less risk associated, then it is suggested to use a lower leverage amount that is 50:1. But, if you are comfortable with bearing higher risk you can go for 100 ratio 1. It is to notice that high leverage can offer you high profitability significantly bringing the risk of losing hand-in-hand.
Experienced level
The second factor that you need to consider while deciding leverage for yourself is experience in forex trading. If you are a beginner or a medium-level experienced trader then you should go for smaller leverage whereas if you are an experienced broker and you know the cliques of market fluctuations and have a good knowledge of changing trends then you can go for leverage that is 100:1.
Investment amount
The third point we have at our fingertip is the investment amount or say the margin amount we are going to leverage on. If you have a small capital account then it is suggested to go for a lower leverage as if there are chances of depletion of your traded amount then it can lead to depreciation of all your fund value.
But, if you have a high investment amount you can prefer going for a high leverage amount, as even if you face the risk of losing the one trade, it won’t affect much of your initial value.
Market Stability
Well, it is often suggested to use low leverage in the highly volatile market as it helps stay stronger, even in the high price fluctuations. And using high leverage, in a stable market can significantly give you a little less risk and more profit occurrence.
Conclusion
So, with this, we have come to the end of our blog and hence we can conclude that leverage is one of the essential elements in forex trading which offers a high chance of making a profit, with a significant chance of incurring risk. However, it is suggested to use less leverage to gain more profit in a constant trading phase.
