Leverage, in the forex industry, is the practice of using a small amount of capital to control larger investments. It has also been termed by stock traders as trading on a margin. Leverage allows the investor to invest in the market with a small amount of money, as long as the broker offers a margin. It is also a way of ensuring profit even when the exchange rates of foreign currencies fluctuate.
Leverage can be considered a type of loan that a stockbroker provides to an investor. To be able to trade in forex with a leverage amount, an investor must have a margin account with a stockbroker. Luckily, no interest is charged on a margin amount given by a broker, so with a margin account, trading in forex can be very simple.
Of course there are advantages as well as disadvantages of leveraging. When working with a small capital, there are chances that investors can make a substantial amount of money. On the flip side, there is also a risk of losing a large amount of money when trading with leverage. The investor would have to be very familiar with how leverage works, and would also need a higher risk-taking ability.
Types of leverage amounts
The amount of leverage granted is usually fixed and depends on the broker. A broker may give out the leverage according to set regulations. These leverage amounts can vary from 50:1, 100:1, 200:1 and 400:1. Understanding this ratio is very simple. For every $1 that the investor has in the account, the broker will give out $50 for trading in forex. For instance, if an investor was given leverage at a 50:1 amount, and the investor had $1000 dollars in his/her account, he/she would be able to trade with up to $50,000 dollars. It is not necessary to use the entire $50,000 at once while trading. The limit up to which the investor can trade would be up to $50,000.
Similarly, a 200:1 ratio of a leverage amount would mean that for every $1 in the investor’s account, the broker would give out $200. The 100:1 leverage amount is the most common type of amount given out by a broker for a standard lot account. Typically, an investor has the ability to control a whopping $200,000 with a standard $2000 minimum deposit amount in the account. On a mini lot account, the most common type of leverage provided is 200:1. For these types of account, $300 is usually the minimum deposit amount, and it opens up an opportunity to control $60,000 worth of trades.
Stockbrokers sometimes offer a 400:1 leverage amount. However, it is important to be cautious when dealing with this amount. With the 400:1 amount, the investor can be left completely penniless within a short period of time.
Risks involved in leverage
As with any other types of investments, trading in forex with leverage can be equally risky. It is wiser to work with a small amount of leverage, which is what professional traders normally do. This prevents loss of a substantial amount of money, when trading does not go as planned. For example, if an investor has invested in foreign currency, and the value of the currency goes in the wrong direction, the investor can suffer great losses.
Professional traders often trade with a leverage ratio of 10:1 or 20:1. Contrary to popular belief, stockbrokers allow this amount as well, as long as the investor deposits a larger sum, and trades fewer times. To prevent huge losses in forex trading, traders make use of stop and limit orders, which are stricter trading styles. Many investors believe that when they have a leverage amount, they need to invest the entire amount. This is a common mistake made by investors. Leverage, when used in small amounts, can lead to more profit, and reduce the chance of losing the complete amount.
When working with leverage, it is important to remember that the risk factors are quite high. It is always better to use less leverage. Traders who are novices in the area of forex trading should take some time to thoroughly understand how leverage works, and then use the leveraging strategy. This ensures minimum loss, and more profit in trading.