Traders in Forex trade a contract of currency exchange rates. As the movement of currency rates can be very small, traders use leverage to increase their profit potential.
Leverage means borrowed funds in general terms. Since it is very used to trade financial assets such as equities and foreign exchange, in this case, leverage is the ability to control a large amount of money using very little of your own money and borrowing the rest.
Leverage trading is what makes the currency market to attract many investors.
With leveraged Forex trading, there is more money to use for trading than the balance in your account because it is possible to “leverage” the amount of money available.
That means to use what you have to increase the amount you can trade and to increase your profit when you succeed in trading. On the other side, when there is a loss: the higher the leverage, the quicker you are subject to automatic closure of your deal.
That there is a difference between maximum leverage (Forex leveraging given by the broker which is the highest leverage you can trade with) and used leverage (leveraging depending on your trading/open positions). One is the broker’s (maximum) and the other is trader’s (Used).
The maximum leverage is also called margin, the amount of money required by your broker to allow you to continue trading with the borrowed amount.
Leverage trading, or trading on margin, means that is not required to put up the full value of the position. It is possible to open a larger position than you would be able to if you needed to fund your trade in full. Otherwise, if you were trade Forex without leverage it would not be as profitable as it is.
Experienced traders use leverage every day because it is an efficient use of their capital. Trading using leverage allows traders to trade markets that would otherwise be unavailable. Leverage also allows traders to trade more contracts (or shares, or currency pairs, etc…) than they would otherwise be able to afford.
Trading on leverage increases the potential for profit, but also increases the risks. While contingent orders may not necessarily limit your losses, actively managing your positions using limit and stop orders allows you to set the maximum loss you are prepared to take on any one position.
Hence, the use of leverage in trading is like a double-edged sword. This is more so in the case of Forex trading, because there are high degrees of leverage.
Forex trading offers leverage up to 50:1. This means that for every $1 in your account, you can trade $50 worth of a position.
A few safety precautions used by experienced traders may help mitigate the risks of leverage in Forex trading:
- use strategic stops (not just to ensure that losses are capped, but also to protect profits);
- cap the losses (to within manageable limits before they get out of hand and drastically erode your equity);
- use leverage at your comfort level (If you are a relatively cautious investor or trader, use a lower level of leverage that you are comfortable with);
- be wise (do not try to get out from a losing position by doubling down or averaging down on it).
At conclusion, we could say that the more leverage the better, because trading with leverage has several advantages. But it is always important to use the right precautions whether you are a beginner or an experienced trader.