Should you use leverage in forex trading?
One popular trading tool used by many investors is leverage. It allows you to borrow capital from a broker.
This can then be used to open positions. This can increase the size of the positions you open. In this article we talk about leverage and if it is right for you.
When trading, leverage is a fantastic tool. It allows you to borrow money and increase the size of your trades. While this allows for greater returns, it can also mean bigger losses. Below, we discuss leverage in forex trading and if it is right for you.
What is leverage?
Forex trading, unlike other types of asset investment, requires large amounts of currency to be purchased. The reason for this is that the markets for currencies will only move by small amounts each day. This means forex is less volatile, and as a result, more can be risked.
The forex markets are also measured in pips. These are usually the last points on a four-decimal number. For example, if the GBP was worth £1.0000 and moved to £1.0001, it would have moved one pip. A movement of a pip is miniscule and will be worth a fraction of a pence. Thus, to get any value from them you need to invest large amounts of capital.
As an investor, that means that you need a lot of money in your bank to open a forex trade. This is not always possible. Leverage acts as a loan from the broker so that you can invest more than you have.
Leverage ratios
Leverage is expressed as a ratio. For example, other assets may have ratios like 3:1 when it comes to leverage. In forex, these ratios go much higher as the risk of loss is less.
The first number is the amount that your investment, as a trader, is being multiplied by. So 3:1 would mean for every unit you invest, you can use three times the leverage.
The second amount is the margin. This is a deposit of sorts, that the broker will hold to offset the risk involved. It is also sometimes known as the initial margin, and can vary depending on the broker’s preferences. This is the amount the trader needs to have in their account to act as a deposit for the loan. So in the above example, if a trader would need to have £1000 in their account as a margin, to initiate a £3000 trade.
This is often expressed as a percentage and may be called the margin requirement. So if the ratio is 50:1, the margin requirement is 2.00%. If it is 100:1 it is 1.00% and so forth. When you look at your trades and account, particularly when using online platforms, you may see other kinds of margin alongside the margin requirement. The meaning of them is summarized below.
Used margin
This is the amount your broker has put away. It is used to keep your current positions open. It is returned to you when your positions are closed.
Usable margin
The money you have available which can be used for new positions and leverage.
Margin call
This happens when your equity falls below your used margin. You must deposit more money into your account or all current positions will be closed by the broker.
Why you should consider using leverage in Forex trading
The main benefit of leverage is that it can mean a higher return on your investment. You can invest more in the trade, and this naturally results in bigger returns. This allows you to get better yields than you could achieve with your capital alone.
Leverage also allows more flexibility, if you decide to invest outside of the forex market. You can use it to spread your capital, taking positions in a wide range of assets. This provides stability and spreads the risk of your portfolio.
What are the risks when using leverage?
Leverage sounds like a great idea for traders, and it can be. However, it does also have its drawbacks as you are essentially risking borrowed money. To counteract this, most traders using leverage have a range of tools to minimize the risk involved.
Stop loss orders are the backbone of this, and one you should be using as a forex investor who is trading on the margin. A stop-loss order will exit you from a trade if the market moves against you. You set the amount you are willing to lose beforehand, and when it hits this amount the trade is exited. There are different types of stop loss you may wish to consider, such as trailing and guaranteed.
A take-profit order works in the same way. However, you specify a price you want to cash out at when you have made a profit. This ensures you are not chasing higher amounts, which may end up turning into downward trends.
Is leverage right for you?
This all depends on your balance and the level of risk you use in your trading methods. It does allow you to invest more money than you already have. However, this comes at a cost. If you are averse to risk then you may want to forget leverage entirely. For others who have a high-risk tolerance and want bigger yields, then leverage should be considered.