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Trading is becoming popular in the digital age of the 21st century. This is due to the fact that it has become increasingly easy for people to register and start investing in currency pairs on the foreign exchange market (Forex). It provides a way of making extra money or even more enthralling – becoming richer. Trading only requires a working computer, tablet, or even a smartphone at hand. As technology advances the consumer-grade hardware has become quite affordable. Mainly due to this a lot of people have realized that whatever they have at home can not only be used to watch some videos or play games but to make some extra bucks as well.
Trading on forex is not easy though. While accessible it still requires a lot of insight into finances which means an in-depth understanding of things like how volume impacts the prices, what is leverage in Forex, and etc. All of this is basically a prerequisite to understanding which broker is better, which trading platform to trade on, correctly anticipate market movements, analyze news, and subsequently make decisions on when to open or close trades so that the trader doesn’t lose his or her investment.
Trading is also associated with a lot of stress. This is mainly because of the ever-changing nature of financial markets. Even if you have made a proper analysis of the whole information at hand and made a very educated decision about when to open a trade there still is quite a high chance that some statements or an ongoing problem in the country may trigger a shift in the market. Emotional stability is key in this sense as there are a number of uncertainties that will be constantly going through a trader’s mind. Not only that but the leverage cuts both ways so as it gives the ability to make profits it also enables you to lose more money if something doesn’t go your way. This is why it’s important to know exactly how to trade FX with leverage and make sure that you keep a leveled mind during the work process. There are viable reasons why traders are working hard to avoid emotional trading and trying their best to not overextend. Emotions may lead to oversight or rushed decisions that may cost you your leverage on the Forex market. In an unstable emotional state, things will look rational but questionable at best post-factum.
Rookie traders have a vast array of free information that they can go through to get themselves prepared for the market. Before one delves into actually investing and dealing with real money they have to understand the strings that control the system. There are a number of things that a trader needs to know and leverage is one such thing.
What Is Leverage?
One of the main draws towards the foreign exchange market is higher leverage than in comparison to others like stocks, bonds, or even cryptocurrencies. The concept is quite easy to understand but not a lot of people bother with learning the proper way of putting it to good use. Imagine taking other people’s money and using it to enter the market. However, it is a double-edged sword that cuts really hard both ways. If properly utilized, Forex leverage is a powerful tool at the hand of a trader but in case of misuse, it may and most likely will damage the financial integrity of the individual.
Leverage technically is borrowing a certain amount of money from the broker to make a proper investment. The amount of leverage that differs from broker to broker but more than usually the amounts depend on the types of accounts. Forex trading is good due to its high leverage. This means that for the size of the initial investment the trader can actually build up and control a much bigger amount of money. This is called the initial margin and margin-based leverage. In more technical terms the margin-based leverage for Forex is calculated by dividing the total transaction value by the number of margins you are required to invest. So basically, if there is a 2% deposit of the total transaction value which is about $50,000 the margin required would be $1,000 so the margin-based leverage is 100 to 1 (100:1).
The concept changes a bit when it comes to margin-based leverage as it does not affect the risks and the percentage of the margin value which also does not necessarily influence the profits or losses. The formula to calculate the real leverage is quite easy as well. It is the total value of your open positions divided by trading capital or the total value of transactions. So if you have $1,000 on your account and you open a position for $10,000 it means that you will be trading with 10x leverage on your account (10,000/1,000).
This means that the margin-based leverage is practically equal to the maximum amount of real leverage at the disposal of the trader. In reality, though, most of the traders do not utilize the full amounts on their accounts to trade which means that their real leverage is different from the margin-based one which is usually Forex trading with leverage x2 or something around that mark. As a rule of thumb, a good trader only uses their leverage when he or she has a clear advantage. This falls under the amount of risk the trader wants to take.
Risk of Potential Loss
The risk of potential loss of capital can also be calculated. This is done in the number of pips. As a general rule, most of the traders go by this loss should never exceed 3 percent of the trading capital. Although this number also depends on the individual trader. Everyone is judging their risk parameter through their own experience level which in term determines their Forex leverage trading amount. This means that a trader may deviate from a 3% rule for as much as they feel comfortable with. If a position is leveraged to the point where the potential loss exceeds this number or is something marginally bigger like 20% or more then the trader should try to reduce the risk since if the market goes haywire the investor will face serious financial consequences.
Traders have the ability to calculate the level of margin for themselves as well. This can be done quite easily by taking into account how much worth does an account has for each move in pip. For example, if an investor wants to trade 10 minis for some currency pair lots and each mini account is worth $1 when trading 100 minis the total will amount to $100. This means that each move in pip will be worth around $100. So it is logical to set up a stop-loss order at around 20 to 30 pips which would represent $30 for a single mini lot to not overextend on the leveraged forex trades. The trading is not done using single mini lots as this would not amount to much gain even in the long run. Thus, if a trader has a capital of $10,000 the 3% maximum risk rate rule will give us around 30 mini lots to trade with. Again, this heavily depends on the trader at hand but in general, is considered a good practice due to the nature of the market since losing on the position has a quite high probability.
Forex Trading and Leverage
The foreign exchange market has as much as $5 trillion worth of currency exchanges going around daily. This easily puts it on the top of the biggest financial markets out there. Trading on FX is done via buying and selling the currency pair exchange rates with the revenue coming in from the move in the rate at which point the trader closes the position (sells the bought “assets”). Forex rates are shown in bids and ask prices with the broker. This means that when the trader wants to buy the currency they will pay the asking price and then be paid out in bid price once they want to close the position.
The investors utilize Forex leveraging to enhance their profit from trading. As we have already mentioned, the FX market offers some of the highest leverage out there. This means that a trader with $100 on their account can trade for much higher amounts of money. The brokers offer such high leverage due to the fact that in the case of proper management of an account the risks are quite manageable. This is also reinforced by the fact that since Forex gives the ability to enter and exit trades at any desired moment if things go bad the trade can be stopped at any moment as damage control.
The currency movements are counted in pips. These are the smallest changes in the currency exchange rates and are different for various currency pairs. As an example, in GBP/USD 1 pip is 0.0001. This means that the movement of 1000 pips is going to earn you $0.10 cents. To offset the small amounts of revenue the trading is happening in large batches with high leverage Forex. This means that a trader is going to be dealing with much higher numbers than which may be situated even around $100,000 or more. If trading with such amounts a 100 pip movement (1 cent) is going to net you a gain or loss of $1000. This is why the trade itself is quite stressful due to the fact that mismanagement may lead to a huge monetary loss. So for example, if the market moves by a big amount of pips like 1000 you will lose or gain $10,000.
A Hidden Catch
From what we have discussed everything seems like quite an easy affair, right? The thing is that the reality is quite a bit less glamorous. Trading is not as easy as looking at a chart of price movements and then running with the first thing that comes to mind. There are a number of risks associated with trading and the leverage while being one of the best allies, can also become a huge financial burden. Since we have already discussed what is Forex leverage it should be becoming increasingly obvious where it may become the downfall of a trader.
It is important to stress the fact that while the leverage is increasing the profits by a certain margin it is also increasing the losses at the same time. This is why a lot of experienced traders usually classify leverage as a double-edged sword. If used properly in the correct situation it will amount to crazy revenue but one unlucky trade and significant losses are bound to come. So choosing a broker, for example, is not as easy as just finding one with the highest leverage. The trader needs to understand their own mental and more importantly financial capabilities and assess them to the best of their extent until they start investing with high leverage.
To illustrate bad methods of how to use leverage in Forex let’s think of a hypothetical situation where we have two trader brothers – Jack and John. Jack is a daring type and John is the careful one. Both of them are trading on the same platform with the same amount of leverage and have $50,000 on their trading accounts. The broker requires only a 2% margin deposit which is $1000. One day brothers sit down and analyze the market coming to the conclusion that a EUR/USD pair is hitting its maximum mark and will start to fall soon. So they decide to sell at the point where 1 USD becomes 0.82 EUR.
Jack is feeling extremely confident so he decided to apply as much as 50 times of his real leverage on this trade which makes it $2,500,000 (50 x $50,000) while John goes carefully and decides to apply only 10 times his real leverage which becomes $500,000 (50 x $10,000). However, their analysis does not yield to be true and the price shifts up to 0.83 EUR. This will amount to a loss for both of the traders, however, since Jack overextended his abilities he ended up with a loss of as much as $25,000 which is half of his whole capital while John, due to his careful approach, only lost as much as $2500.
The difference between the two is quite visible. One of the traders lost half of his capital while the other only a fraction of it. This is why it’s important to know how to trade fx with leverage so that the trader does not overextend and net huge financial losses.
Conclusion
Overall, while there are certain precautions a trader should take when trading with leverage it is not your ultimate enemy but can be a useful ally if used correctly. This is mainly why forex trading is considered a risky endeavor where a lot of people can thrive if they are knowledgeable about their decisions. The idea is that there are a number of tools at hand that let you grow your revenue but they may work against you in times of uncertainty. Leverage can and is used successfully to provide profit by lots of traders under proper management.