Leverage is a term that is often bandied about in forex trading, but it is important to understand how it works. Forex traders speculate on the forex exchange markets with a view to making money. Leverage maximizes their returns on an investment, turning a small gain into a very large one. This is how some traders make a lot of money very quickly. However, leverage can also backfire, as we shall explain later.
How Does Leverage Work?
Most forex brokers provide some leverage on a trader’s account. The amount of leverage available typically varies between 50:1 and 200:1, depending on the value of the trade. There are brokers out there that offer much higher leverage, but high-leverage accounts are best avoided unless you are an experienced trader – or you like living life on the edge. Have a look at the brokers with high leverage selected by InvestinGoal by following this link. (Note that the list is only applicable to traders who are EU residents). InvestinGoal are a great resource for learning about trading and investment.
Leverage lets you trade with a minimum investment. So, if your broker offers a 100:1 leverage, you only need $1,000 in your trading account to open a $100,000 trade. This may sound like a risky trade if you are a newbie, but the reality is that currency prices barely move by more than a few pips, so you the risk is lower than it would be if you were leveraging an equity trade.
The Downside of Leveraged Trades
Leverage helps forex traders maximize their gains, but it also amplifies their losses. You stand to lose far more than your stake. If you apply too much leverage to a forex trade, you could wipe out your entire trading account.
Smart traders learn how to manage leverage. They use tools such as stop losses to avoid huge capital losses. Just because you believe the market will move in one direction, it doesn’t mean it won’t turn against you.
Implement Strict Trading Limits
Practice risk management when trading forex. Always have limit orders and stop losses in place to minimize your losses. Calculate your exposure to risk before you make a trade. Ideally, don’t risk more than 3% of your trading account on any one trade. Any more than that, and you might not recover so easily.
Don’t be Afraid of Leverage
Leverage really is nothing to be afraid of. Once you get a handle on how leverage works in the forex markets, you can use it to earn huge profits. Most forex brokers let you customize how you apply leverage to your trades. This is where a demo account can come in really useful.
Use a demo account to practice your trading strategy. Get a feel for leverage and how it influences the trades you make. You can see how leverage affects profits and losses, without risking any of your hard-earned money.
As long as you are cautious and don’t chase losses, leverage won’t trip you up.