Trading the forex markets is attractive for several reasons and one of the most important features is leverage. Investors love the idea that they can borrow capital to enhance their returns, at levels that are not available in other capital markets. Whether you are a newbie trader on the Forex market or have solid experience, you have certainly already encountered the concept of leverage. Trading on leverage can significantly increase your profit margins without having to put down a massive initial capital.

But first, you need to know what you’re doing. As Warren Buffett famously said, “When you combine ignorance and leverage, you get some pretty interesting results.” In this article, we will take a closer look at ABCs of leverage in trading, how it works, and how you can use it as part of your trading strategy.

Definition of Leverage

Leverage is the force in trading that enables traders to take exposure to artificially amplified transaction sizes, in order to make more money from each individual transaction. Leverage gives traders the possibility to use borrowed funds to purchase an investment tool. When trading on Forex, borrowed funds are provided by a forex broker. The availability of large leverage on Forex allows traders to manage significant amounts in the market, having just a small part of funds coming from their own deposit used to cover margin requirements. To calculate the leverage amount, you need to divide the overall amount of the transaction by the required amount of margin.

Leverage = 1/Margin = 100/Margin Percentage

Example: If the margin is 0.02, then the margin percentage is 2%, and the leverage = 1/0.02 = 100/2 = 50.

The amount of credit funds available to the forex trader is estimated by the margin requirements of the specific broker. Margin requirements are mostly expressed as a percentage, and leverage is written as a ratio. For instance, the margin requirements of a broker are 2%. This means that to open a position, the amount of the client’s available funds must be at least 2% of the total transaction amount. In this case, the leverage is 1:50. The use of 1:50 leverage lets the trader to operate on the market $ 50,000, having only $ 1,000 in his trading account. For such a leverage, a 2% movement of the trading instrument on the market will either result in total loss of funds or double the account.

How Leverage works

Some of the leverage levels offered by Forex Brokers are 1:25, 1:50, 1:100, 1:200, 1:300, 1:400 and 1:500. If we have a leverage of 1:500, then our initial margin will be 500 times smaller than the contract size. Here’s an example of how leverage works: Suppose a trader’s trading capital is $1,000 and trades at 1:500 leverage. According to his leverage, his trading capital has increased by 500 times, which means he has 500,000 (1,000 x 500) to trade with.

For example, the current exchange rate for the EUR/USD pair is 1.1150, and we want to open 1 lot position (100,000 units) which will be 1.1150*100,000 = 111,500 . If our leverage is 1:500, then the margin required for such orders will be $111,500/ 500 = $223. If the trader wants to open a mini lot position (10,000 units) which will be 10,000*1.1150 = 11,150, then such options are required margin will be  11,150 / 500 = $22.3.

What Leverage Ratio is Good for a Beginner?

Let’s figure out what is the best leverage level for a beginner. Many newbies are attracted to the leverage-based earning strategy as they want to make more money in a short period of time.

However, remember that leverage is associated with certain risks. You need to at least understand the concepts that are directly related to money management in leveraged trading, such as:

• Balance and Equity of your account;
• Margin;
• Free margin;
• Account Level;
• Margin Call and Stop Out.

As a new trader, you should consider limiting your leverage to a maximum of 10:1. Or to be really safe, 1:1. Trading with too high a leverage ratio is one of the most common errors made by new forex traders. Until you become more experienced, we strongly recommend that you trade with a lower ratio.

Advantages and Risks of using Leverage

First, let’s take a look at the advantages and risks of leverage for a forex trader:

Advantages of Leverage

There are several reasons why brokers offer leverage. Leverage is offered in many instances of capital markets trading, but forex leverage is generally much higher than any other trading vehicle. The leverage that is offered for US equities is approximately 1.5 times the value of the Currency. So your margin is at most 50% the notional value of the trade.

Forex leverage can reach levels up to 500:1. Brokers are comfortable offering this type of leverage for several reasons.

1.   Increases forex trading profits

The basic advantage of trading forex with leverages is that it gives forex traders the ability to trade forex while making a whole lot of profits in return. Leverage provides a greater yield of returns with minimal efforts. Since a leverage has no bounds in the type of financial asset being traded, it provides a medium where traders yield profits by just staking a minimum initial deposit. Leverages offer traders the opportunity to double their initial trading amount used as trade setup in just minutes. When dealing with a long-term investment, leverages which are borrowed funds is always a stepping stone to boosting all available capitals when properly managed. For example, a forex trader who just has a deposit amount of one thousand dollars in his/her account can actually trade forex with fifty thousand dollars with the help of leverages.

2.   Upsurges capital efficiency

Leverage have in the long run proven to not only increase profits but also increase capital efficiency. When trading forex with leverages (borrowed funds), if it originally took a forex trader a maximum of two months to generate profits and returns with personal funds, a broker’s leverage can get the same trader to make double profits in a shorter period of time thereby increasing capital efficiency. This simply signifies that a forex trader’s capital or funds can be re-invested on several occasions in future transactions thereby yielding more returns and profits. With this, we can say that leverages not only provides greater profits in a short trading period but also generate a considerable amount of return over a short period of time.

3.   Remedy against low volatility

One major advantage of forex trading leverage when it comes to trading forex is that is has proven to be a high remedy against low volatility. Volatile forex trades are seen as those that yield greater profits because the market situation of these assets is more dynamic than the market of other instruments. Due to the careful nature of forex traders when trading currencies and factors that cause price fluctuations, the forex market experiences low volatility at these points in time. This is where forex leverages come in. leverages have the ability to counter the effects of low volatility simply by generating greater profits from smaller trade transaction sizes. When trading with high leverages, a small movement in prices can become significantly important where forex traders can give more attention to less significant degrees of price movements.

Risks on Trading with leverage

Since leverage grants the forex trader to trade with volumes that you do not presently have in your account, it can also act as a double-edged sword. Forex trading using leverage can cause a lot of damage to a trade and the account of a trader in general. Although leverages come alongside a reasonable amount of profits, the losses incurred are as great. After bearing losses in percentages, leverage ends up costing a lot more damage than you actually bargained for since it entails playing with more money.

For example, a 0.1 percent loss on a twenty thousand dollar trade using the 100:1 on each trade cost more than you can imagine. As it is possible to gain much further than his initial investment, losses can happen in the same way.

It is crucial to keep track of open positions and apply stop loss and other market orders in order to prevent large scale losses. For this reason no matter how much of an expert you are in Leverage trading. It is always best to use trustworthy crypto Forex trading platforms like Winstone Prime in order to make your trading safer and more accurate. And also make sure you have a good understanding of forex money management, so you can continue trading for years to come.

Conclusion

Leverage is a virtual currency borrowed by a trader from a broker to maximize the balance of a trade. When leverages are working in our favor, it is really good for us and produces higher profits, but when it opposes our interests, it can cause huge losses. Therefore, you should be cautious before using leverage in Forex trading.