What is leverage in Forex trading?
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.
Here is a step-by-step, practical example:
- You decide to open a contract for trade and it has these elements in it:
- The currency pair for trading – e.g. EUR/USD
- The direction of the trade – BUY euro and SELL US dollars
- The price – say 1.3500
- The contract value – EUR 100,000
As the trader, you purchase this contract, believing you will profit once you close (offset) the contract.
If you are right (for example: the rate increased to 1.3600), then you would profit: for every euro in this contract you made profit of 1 US cent. In total, the profit would be $1,000 (100,000 x 1 cent).
However, do you need ALL the EUR 100,000 to open this contract?
The answer is: NO. You can LEVERAGE the trading: the trader is required to risk, for example, only 1:100 of the contract value. Accordingly, for a contract of 100,000 only $1,000 is needed. However, if there was loss, and the value of the WHOLE contact dropped to 99,000, then the deal is automatically closed, since the “guarantee” made by the trader was only $1,000.
With leveraged forex trading, you have more money to use for trading than the balance in your account because you can ‘leverage” what you do have – that means you use what you have to increase the amount you can trade and to increase your profit when you succeed in trading in the right direction of a currency pair. On the other side, when there is a loss: the higher the leverage, the quicker you are subject to automatic closure of your deal.
How does leveraged forex trading work?
Leveraged trading works by establishing a rate you can use for every dollar in your account. The money you put for the trade is the actual money you risk. It is called ‘margin” or the amount you risk.
For example: If you invest $100 and leverage it at 1:100, then you have $100 to trade for every $1 in your investment (margin). If you start trading with your $100 investment, you can buy up to a value of $10,000 (100×100).
Why does leveraged forex trading exist?
In the Forex market, leveraged trading exists to create the possibility of making a bigger profit. Leverage is necessary because Forex trades involve very small differences in price. The difference can be a very small part of one cent.
With such small amounts, it can take a long time to make a meaningful profit, as well as bigger initial investments. Using leverage, you can get a return on your investment faster and using smaller initial deposits. Forex trades happen very quickly. When you are using leverage, you should be careful. The higher the leverage used the more chance you have of losing your investment when the currency pair is going opposite to your investment.
You are advised not to risk more than you can accept to lose.
What is a “margin”?
A ‘margin” is the amount you put into the Forex contract you open (the investment which you risk). Online trading brokers must make sure that traders can pay if they lose money when they trade. Traders put money into an account that can be used to cover any losses they make. This amount is also called ‘minimum security”.
With a margin, traders are able to invest in markets where the smallest trade you can make is already high. Margin trading can increase profit, but it can also increase loss.
The profit and loss rates when you leverage your trade
As mentioned, your margin is your investment. Accordingly, you invest a margin of $1,000 for a contract of $100,000. This is a 1:100 rate. If the currency exchange rate moved, for example, 0.5% that would be a 50% change on your margin! Since the contract is 100 times the margin, then the change of 0.5% becomes 100 times bigger, to 50%.
Can you limit your risk?
You can limit your risk by using ‘Stop-Loss” rates. These rates are decided by you, the trader. You choose a rate that is the lowest you want to go. If the market reaches that rate, your deal is automatically stopped so you do not lose any more money.
Because you set the rate, you can control your investment. You can make sure that you do not lose more than you are prepared to.
In the same way, you can set a ‘Take-Profit” rate. Your deal will stop when the profit rate you have decided is reached. Take-Profit makes it easy for you to control your trading without having to constantly monitor your position.
You can change your set rates at any time while your deal is open.
It is important you know that 100% guarantee for pre-set rates is impossible because market conditions might suddenly affect trading. For example, the market might suddenly change very fast, and those involved in the Forex trade might be unable to execute pre-set rates because the trading environment is suddenly out of their control.
easyMarkets aims to make sure that traders are protected as much as possible. easyMarkets makes any and all efforts to guarantee the set rates, unless unusual market conditions prevent them from doing so, one tool to consider is our dealCancellation feature, where a losing trade can be cancelled with zero loss within the first hour.
If you wish to get involved in the Forex market, open an account, for free.