As we know, forex trading has become one of the most popular types of trading in recent years. Here, a trader or an investor would trade in a currency pair, for example – USD/EUR, JPY/USD, to make profits. You simultaneously buy and sell the currencies of the pair that you have selected. Your trade position and level of leverage contribute to your trade strategy. When you buy a currency, it is called a long position and when you sell a currency, you go short. But if you buy currency at 1.3 and it goes up a few pips how you can earn? Traders need a big amount of money so they can make any decent profit. They need leverage. The next question is, what is leverage? Read to know more about Forex trading leverage meaning.
What does leverage mean in forex?
We tried to give leverage definition in our article What is 1:100 Leverage Meaning.
Leverage is the ability to use a small amount of capital in traders’ accounts controlling a larger amount in the market. What is leverage in trading terms? Leverage is the ratio of the trader’s funds to the size of the broker’s credit. Brokerage accounts allow the use of leverage through margin trading or in other words, brokers provide the borrowed funds to traders so they can increase trading positions. The leverage ratio can amplify both profits as well as losses.
So, the capital or the borrowed money that you invest in a currency pair is called the leverage. This is the money that is different than your minimum deposit. But, how leverage works in trading? Traders borrow money from their brokers so that they can trade larger positions in Forex. Brokers charge a percentage on this borrowed money. For every dollar that you earn using this borrowed sum, you have to give a part of it to the borrower. Since you have to pay interest on the leverage, you must be careful before selecting the level of leverage. Let’s find out what is the optimal level of leverage for forex traders and investors.
Which is the Best Level of Leverage?
In trading, everything is subjective because everyone has a different strategy and goals. To say that a certain level of leverage is the best would be off the mark. Your optimal level will depend on how you are planning to trade and the expected movements in the market. For example, breakout and scalper traders look for quick trades which means that high leverages will be better for them. On the contrary, lower leverage is better for positional traders.
You can see how your leverage resonates with your position, goals, strategy, and the expected market movement.
How to Choose the Best Leverage Level for Forex Trading?
Irrespective of whether you have experience in Forex trading or not, always make decisions based on your comfort level and the risk that you can bear. Your broker may offer you different deals and leverages, but you need to decide if you are satisfied with that before finalizing anything.
Online Forex brokers give you various options to choose from. The leverage can be anywhere from 1:1 to 1:1400. Generally, 1:100 leverage is considered a desirable level for Forex trading. What does 1:100 leverage level mean?
It means that if you invest $1000 at leverage equal to 1:100, your total trading amount will be 100 times your investment. That is $100,000 in this case. Leverage allows small traders to trade higher volumes. It allows them to trade beyond their means.
Many new traders fall in the trap of looking for a higher level of leverage, expecting to make more profits using it. This is not an ideal practice. Higher investment leads to higher profits but it can also lead to higher losses as well. High leverage can be a problem if you don’t have enough experience in managing it. You need to learn how to manage leverage risk to keep debt from getting accumulated.
Is high leverage good in forex trading?
This question is very similar to the question: Is a lot of food in your house is good for your health? You can put a lot of food in your house but you do not need to eat everything that you have. The same principle is in trading.
So, is high leverage good in forex trading? The possibility for a trader to have large leverage can be an advantage in trading especially when the market is in the small range. The most important thing is that traders do not risk a lot of money, trade on a margin because that can bring to huge and fast loss.
Another example is a fast car. If you have a fast car, it is not a bad thing, if you make sure you drive at the speed limit. The same thing is with leverage.
Managing Leverage Risk
Never forget that leverage is nothing but borrowed money and whether you make profits or losses using it, it still needs to be repaid. Forex trading markets are seldom linear. The price movement may not be dramatic but the chances of making profits and losses are equal. Higher leverage can lead to increased losses. However, with proper risk management, you can use leverage to expand your investment.
This is how it can be done:
Use a part of the investment: Trading with the entire capital is never a good option. You can avoid possible negative results by using a part of it at a time.
Use risk management tools: There are many risk management tools like a stop-loss order that you can use to your advantage. You can find such features on your trading platform.
Hold small positions: You can effectively manage the risk by holding small positions as they require less investment.
Forex leverage can open a lot of possibilities for you. It allows traders with limited capital to maximize their profits. Forex leverage is customizable. You can discuss this with your broker and choose a ratio that you are comfortable with. Never neglect the risk involved with any kind of borrowing. You must hope for the best but prepare for the worst. Leverage has the potential to maximize both profits and losses. Use risk management tools to keep yourself floating.