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Understanding Leverage In Forex Trading – Why You Should Use It With Care

16 July 2020 No Comment

For newcomers to trading forex, the concept of leverage is one that excites them greatly. That is because they can access higher amounts of capital to maximize their profits!

Well, that’s the idea, anyway.

Of course, trading forex isn’t always straightforward, and unforeseen changes in the market can lead to losses – which are exacerbated when trading with leverage.

There are pros and cons to leveraged trading. In this article, we will take you through everything you need to know about leverage when trading forex.

What is leverage?

If you are entirely new to forex trading, you might not even know what leverage is.

Essentially, taking out leverage is a ‘loan’ that gives you more money to invest in your chosen forex currency pair(s). These borrowed funds enable you to open positions at a far greater quantity than you would otherwise be able to afford from your bankroll.

The idea is that when a trade moves in a positive direction by even just a few ticks, the profitability of your position is significantly enhanced. And so, as ever, effective trade management is vital.

Why use leverage in trading?

We’ve already hinted at the main advantage of using leverage in your trading: you can invest more money in a currency pair, and positive positions earn the trader a higher return as a result.

And that’s the bottom line of leveraged trading. You can increase your financial muscle by borrowing extra capital and maximize your edge over the market.

The disadvantages of leverage in forex trading

So leverage is free money, right?

Well, not precisely, and we have to consider the other side of the equation. If you open positions with leverage and pump more money into the market, what happens if a trade goes against you?

Naturally, your losses are a whole bunch higher too. Let’s say you have used $1,000 with a 100:1 margin – this effectively means you are trading with a $100,000 bankroll.

Now, if the market moved against you a couple of ticks with a $1,000 investment, your open position might be showing a loss of, say, $50. Not great, but not the end of the world.

But think about the same scenario with that 100:1 leverage – your loss now stands at $5,000, which is 5x your bankroll!

Situations like this put you at risk of a margin call. This is where you might be unable to fulfill the terms of a trade. In margin trading, where your broker lends you the leveraged funds, if things go badly, your broker can liquidate your portfolio and close your account when they take a margin call.

That is a worst-case scenario, of course, but an example of the downside of leveraged trading.

The bottom line

As you may have gathered by now, there are obvious upsides to using leverage, and if you trade appropriately, the added risk can still be managed effectively.

However, there are unforeseen variables in the forex market that can outfox even the most experienced of traders – with leverage added, that can lead to some tricky predicaments.

The good news is that the forex market is highly liquid, and so you will always be able to exit a position when necessary – the use of a stop-loss is also advisable in leveraged trading.

Most trading brokers offer customizable leverage, from 50:1 right up to 200:1, and so if this is how you plan to trade, then make sure you find the right firm for your needs – obviously, checking broker reviews is important. Doing so will help you to find a reputable broker that will provide the services you need.

The bottom line of leveraged forex trading is don’t be fearful if you have a proven track record of winning trades – if you don’t have that, leverage can be a very daunting concept indeed.

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