Leverage in forex trading – boon or bane?
Forex trading presents vast opportunities for potential profits due to its massive size and daily trading volume. Moreover, forex traders have access to the highest leverage levels, allowing them to control larger positions with smaller amounts of capital. While leverage can amplify gains, it’s crucial to be aware of its advantages and disadvantages before using it as this will help you manage your risk effectively.
What is high leverage?
Leverage is a kind of loan that traders borrow from their brokers to amplify their trading positions. This allows them to control larger positions in the market with a smaller amount of their own capital. The capital required for a leveraged position depends on various factors, such as the trading platform, instruments, and brokerage firm being used. Moreover, you should also calculate the pip value manually or use a pip calculator to determine the pip value. This will help you decide the right amount of leverage you should employ.
If you are wondering how leverage can make your positions bigger, then let me first tell you that forex brokers offer different levels of leverage ranging from a ratio of 1:50 to as high as 1:1000. With a high leverage ratio of 1:1000, if you invest $50, you have the potential to trade with a position worth $50,000. This attracts small traders who aim to make significant profits in a short period of time. However, higher leverage also means higher losses which many beginners neglect. So let’s take a look at the advantages and disadvantages of using high leverage in forex trading so you can use leverage smartly.
Pros
- Low capital investment: Leverage trading has become highly appealing to retail traders for a compelling reason: the opportunity to earn significant profits. In the past, only wealthy traders could access such lucrative opportunities, but these days, regardless of your financial background, anyone can aim for substantial gains in forex trading. Using leverage, traders can enhance their capital efficiency, treating their capital as an asset with profit-generating potential. Let’s illustrate this with an example: Suppose you can earn $400 within three days through regular, unleveraged positions. With leverage, you have the potential to achieve the same earnings in a much shorter time frame. This enables you to reinvest your capital repeatedly, compounding your returns and maximising your overall yields.
- Interest-free: Leverage does not come with interest charges, another big benefit of using it. When you utilise leverage, you borrow funds from your brokerage firm to increase your trading capital. You can access these additional funds without worrying about incurring interest expenses. This allows you to leverage your trading positions without the burden of interest payments.
- Huge profits: Leverage offers the potential to earn significant profits in a relatively short period of time. Regardless of the amount of money you initially invest, leveraging allows you to amplify your potential earnings. To find out how much you have made in your own currency, you can take the help of a profit calculator. The concept behind leverage is to increase your profit potential by multiplying your trading capital. Even with a modest investment, such as $100, you have the opportunity to generate returns as high as $10,000 with the assistance of high leverage.
- Mitigate against low volatility: While stable instruments may offer limited profit opportunities, leveraging can help capitalise on small market price movements and generate substantial profits. In periods of low volatility, where price fluctuations are minimal, leveraging allows traders to amplify the effects of even small changes in the market. This means that even modest transaction positions can yield significant returns. By leveraging their trades, traders can potentially turn small price movements into larger profits, making it a valuable tool in navigating low-volatility market conditions.
Cons
- Heavier losses: While leveraging can amplify your gains, it can also magnify your losses. The truth about the market is that it doesn’t always move in the direction you predict. Even small price fluctuations can result in substantial losses when trading with high leverage. Therefore, it’s advisable to have a solid understanding of the market and employ proper risk management techniques to ensure that potential losses are controlled and within your risk tolerance.
- Constant liability: When you engage in leverage trading, you are taking on a constant liability. This means that regardless of the outcome of your trades, you are responsible for repaying the borrowed funds. Whether your trades result in profits or losses, you are still obligated to repay the principal amount borrowed from your broker. It’s crucial to carefully consider your financial situation and ensure that you have a solid plan to meet these repayment obligations.
- Margin call risk: Margin Call risk is important when using high leverage in trading. Brokers often have specific requirements regarding the minimum transaction size you need to meet to qualify for high leverage. You may face a margin call if your investment falls below this threshold. This means that your broker will request you to deposit additional funds to meet the margin requirements. Failure to do so can result in your portfolio being liquidated, which means your positions will be closed prematurely, even if they were earning substantial profits.
In this case, you can use Forex tools to find the right stop-loss levels in order to exit from the trades before receiving margin calls. You can also use a margin calculator to determine your margin requirements. Margin calls can be challenging as they lead to unexpected losses and, as a result, disrupt your trading strategy. It’s essential to closely monitor your account balance and ensure that you have sufficient funds to cover any potential margin calls.
Should you trade with high leverage?
Deciding whether to trade with high leverage requires careful consideration of the risk-reward ratio. It is important to assess the advantage of using leverage in relation to the potential risks involved. To make an informed decision, calculate the amount of risk in terms of pips and determine the potential capital loss. It is generally recommended that the maximum loss should not exceed 3% of your trading capital. This ensures that even if the trade doesn’t go as planned, you have limited the potential impact on your overall account balance.
By setting a limit on the acceptable level of risk, you can protect your trading capital and maintain a balanced approach to leverage. Remember, using leverage comes with the potential for increased profits, but it also magnifies the potential for losses. Assess your risk tolerance and ensure that the advantages of high leverage outweigh the associated risks before making your trading decisions. This way, you will be in a position to make the right decision for yourself.
Final words
High leverage can work both in your favour and against you. On the one hand, it increases the potential for making substantial profits; on the other hand, it also carries the risk of huge losses that can deplete your trading account. The key to effectively using high leverage lies in understanding your own risk tolerance and choosing the right level of leverage that suits your trading style and financial goals. It’s important to strike a balance between the potential for higher returns and the risk of incurring heavy losses.
