As a new trader venturing into the world of forex, it is essential that you have a good understanding of both the concept of leverage as well as how to apply it in terms of your own brokers rules and your personal situation.
In simple terms, leverage is the use of borrowed capital in order to increase your position size, which in turn increases your potential to generate high returns in a trade. Essentially you are using debt to finance your trading and can take a position with a value of multiple times the actual funds in your account.
In the forex market, the borrowed capital that you use for leverage is known as margin.
Leverage is expressed as a ratio. For example:
A leverage ratio of 100:1 means you can leverage up to 100 times the amount of capital in your account. In this case an account size of $1000 allows you to trade as if you had an account size of $100,000. In this example given, you are trading with a 1% margin.
Since 2010, financial regulations limited the maximum leverage offered to US residents to 50:1. So if your account size is $1000, you can trade with up to $50,000.
The appeal of increased trading funds is obvious. However, when employing leverage, it is important to realize the risks, and to understand that in the same way that leverage can significantly magnify your potential returns, it also magnifies your potential losses. The more highly leveraged you are, the greater the potential gains and by the same token, the greater your potential losses.
In the hands of the inexperienced trader, a highly leveraged position may result in a margin call and/or lead to the total wipe-out of your capital.
A margin call occurs when your account balance falls below the minimum margin maintenance required. This results in the broker requiring you to liquidate your position(s) or deposit additional funds into your account.
Some guidelines for the use of leverage
– Only trade in a demo account and do not trade live in a margin account with your hard earned cash until you have a thorough understanding of how leverage works.
– Stick with low levels of leverage
– Use stop losses and trailing stops to protect your capital and minimize loss (click here for article on trailing stops).
– Trade with small position size.
– Do not trade with more than 5% of your total account balance in a single trade, preferably no more than 1-2% (for conservative traders).
It is your personal responsibility to choose a level of leverage that you are comfortable with. What is good for one trader is not necessarily right for you. The decision of how much leverage you should use is a personal one and depends on many variables including your account size, your attitude and tolerance for risk and how experienced and comfortable you are in trading forex.