One of the top reasons you might have entered the world of forex instead of sticking with stocks and bonds is the concept of leverage. Through leverage, you can trade large amounts of money and either earn enough to trade without leverage (or even retire), or lose so much money that you immediately wipe out your trading account. You have to understand leverage trading before you try to participate in it, or else you’re going to set yourself up to go bust.
The basics of leverage
If you trade in standard units of 100,000 units of currency and have a 1% margin, you need $1,000. Your leverage will be 100:1, which you can calculate by dividing the units of currency by the amount you are depositing (100,000 divided by 1,000 is 100, so the leverage is 100:1). Another example: if you were depositing $2,000 for the same trade, you would have 50:1 leverage.
Leverage is higher in the forex market than other markets, which is probably one reason you’re trading in this market. The reason is because currency pairs are often more stable than company stocks or other forms of investments and don’t rapidly appreciate or depreciate, allowing your broker to lend you the appropriate amount without undue risk to either you or the broker.
Risk and margin
Of course, the higher the leverage or the smaller your margin, the higher the risk. If you bought one standard unit with a $1,000 deposit and it increased in value by $1,000, you would have a 100% return (your initial $1,000 deposit divided by the $1,000 gain, then multiplied by 100 to get the percentage). Similarly, if the value decreased by $1,000 instead, you would have a -100% return and would quickly be broke.
The amount you deposit is the margin. If you deposit $2,000 on a $100,000 currency position, your margin is 2%. Margin generally varies depending on the broker, and can be anywhere from 0.25% to 5%. If your margin is 0.25% and you deposit $250 on that same $100,000, the tiniest change in the market can deplete your funds instantly.
Decide on your real leverage
The margin-based leverage on your account is less important than your real leverage – the 50:1 or 100:1 number, for instance. If you invest $1,000 in shorting $10,000, you will lose much less money if you lose pips on a currency rising in value unexpectedly than if you short $100,000. Instead of risking as much as you can, try to keep your investing goals in mind.
If you have spare money and you don’t mind risk, by all means, get 50:1 or even 100:1 leverage and enjoy the potential profits – just be prepared to lose your investment quickly, too. For beginners or intermediate traders, it usually makes more sense to avoid highly-leveraged trades and stick to more reasonable leverage like 5:1, 10:1, or 20:1.
Now that you have a basic understanding of leverage, try leverage trading currency pairs as a potentially lucrative investment, and revel in not having to come up with the full amount to trade the market. Just don’t be too hasty and rush into a trade without taking a good look at the leverage you’re applying to the trade.
This Guest post is contributed by Stacy Pruitt, a freelance forex strategy and finance writer. Stacy writes about advanced trading and forex indicators. Click here for advanced videos on forex trading.