What is leverage in forex? Risks you should know

When it comes to leverage, this is a tool quite familiar to forex investors. However, there are many people who really do not fully understand the importance as well as the impact of leverage on profits and many risks in forex investing. So what is leverage in forex?

In fact, we do not know that leverage is a double-edged sword, there are many traders who successfully apply them to make very high profits, in contrast, many traders have to be empty-handed because of the leverage. So what is leverage? What are the risks of using leverage? Join me to find out so you can trade forex in the most effective way.

What is leverage?

Leverage is a loan offered to you by your broker, allowing you to execute a trade of much greater value than your own trading account in order to benefit from the movement of the price. . On the forex market, the daily price change usually fluctuates approximately 1%, relatively small compared to the stock market. This is why forex allows high leverage, since a small change in price can then result in a substantial amount of money in large positions.

What is forex leverage? That is, you deposit or deposit a small amount of cash and then borrow a larger amount of cash to trade on credit.

leverage-in-forex

One concept that often comes with financial leverage is leverage. So what is leverage? This is understood as a financial measure between the total value of the transaction and the amount of capital a trader spent to trade.

About the calculation formula: Financial leverage = Total transaction value / Total trading capital

The leverage ratio depends on 3 main factors:

  • A market in which a trader trades
  • Size of the trading position
  • Your transaction object

You can simply understand “leverage” is the ability to control a large amount of money in which using very little of your own money and borrowing the rest, while the leverage ratio is the rate of amplification. capital invested through borrowing.

Forex brokers typically offer leverage at 20: 1, 50: 1, 100: 1, or even 400: 1. For example, 100: 1 leverage means you can open a $ 100,000 position with just $ 1,000 of equity.

See also: What is forex? 7 fundamental definition about forex

What is Margin Call?

Margin call is the minimum amount required to execute a leveraged trade.

Closely linked with margin is the concept of margin call, which is perhaps the most important term for traders. Margin Call, which means that after the investor sets up the trading orders, the order is still running, but unfortunately the market goes in the opposite direction of the investor’s prediction, causing the trading orders to be unprofitable and unprofitable. the more the Free Margin decreases, while the capital also decreases, the Margin Level also decreases.

To use leverage, you need collateral for the loan, called a margin. The broker will automatically define a portion of your account as the margin for the position.

The amount of margin will depend on the leverage you are trading. For example, 100: 1 leverage requires margin at 1% of the position’s size. The table below summarizes the margin volumes required for different leverage ratios.

Leverage ratioMargin required (% / value of the position)
1:1100%
2:150%
10:110%
50:12%
100:11%
200:10.5%
400:10.25%  

As you can see, trading with 400: 1 leverage only requires 0.25% margin. This may seem tempting, but you also need to know that high leverage always comes with high risk. It could be said that leverage is a double-edged sword. Because if a position using leverage goes against you, you will make your losses significantly increase. Leverage increases potential profits but also increases potential losses!

Margin calls happen when your leveraged position goes in reverse, causing the value of your trading account to drop below the required margin. The broker will automatically calculate this value, based on the net asset value (NAV).

See also: Leverage (finance) meaning from Wikipedia

If a margin call occurs, the broker will automatically close all existing positions at the rate at that time, and your account will be left with only margin. For example, you would trade a lot, worth $ 100,000, leverage 100: 1 on a $ 3,000 account.

The broker will define $ 1,000 in your account as margin, so you will have $ 2,000 left as “non-margin”, which can be used to make other transactions or to fend off price fluctuations. If the position goes against you, and the loss at that point is more than $ 2,000 “non-margin”, you will receive a margin call.

Risks when using leverage

Leverage always carries potential risks for traders

Leverage can amplify risk many times. This is the reason why traders burn out quickly if trading losses and using extremely high leverage. The only way to overcome this risk is to choose the right leverage ratio – that is, you can withstand an amplified loss if a risk occurs.

You don’t actually own property. You can only buy and sell to benefit from the spread. When the market price trend changes, exchanges can make a margin call – a margin call that requires you to top up more to retain control of the asset. And if you don’t give more money – of course you will exit your position and burn your account.

When using leverage, if you want to do an overnight trade, you will have to pay extra swaps to hold your position.

Although there are many risks, but financial leverage gives you the following benefits

Helping traders open up big positions with only a small amount of capital. You only need to deposit a small part of the trade and use the leverage you want, up to 400: 1. To open 1 $ 1000 position, you only need to spend $ 2.5.

Great tool for speculation and short selling. Traders can benefit from assets that are supposed to depreciate in the future with amplification by many times.

Helping you to access good assets in the market. You do not need to spend too much money but can still trade on reputable assets with large transaction frequency.

You can use leverage 24/24 – it is ready to use day and night.

In general, leverage is like a “double-edged sword”. Before using this tool, traders need to learn about both leverage and margin, the advantages and risks that this tool brings. Besides, understanding how to use leverage in the markets is also an extremely important factor to help you succeed.

In addition, you need to develop your own risk management strategy – that is, set Stop Loss levels as well as take profit, and choose a leverage ratio that you have “enough power to do.” “To bear if a mishap occurs.

Before trading with “super huge” leverage, be sure to have trained well on demo accounts and do a thorough research on the asset to be traded as well as the price trend in the market. previous school. Using technical analysis tools will also help you to make better investment decisions.

In a nutshell, for those new to the market it is a sincere advice to start trading with a Demo Account before deciding to invest and trade with real money, which will help you get acquainted and experience with the market, understanding how the market works, then you can consult and build a low-risk trading strategy by yourself.

Solution for trading in forex with small capital

While trading with leverage can lead to higher returns on successful trades, it also carries the risk of amplifying losses. However, there are risk management tools that you can use at your disposal to help reduce potential losses.

  • Stop Loss: Use Stop Loss to close a trade in the event that the market moves a specified amount against your position. You can set your Stop Loss to a specific level in the market.
  • Take Profit: Place a Take Profit order to automatically close your position when the profit on your trade reaches the amount of your choice.
  • Negative Balance Protection: In the rare cases when market conditions cause your equity to be negative, you should absorb your loss and reset your equity to zero.

The movement of the GBP / USD pair after Brexit, as an example, can wipe your account clean if you open a long position during that time without accompanying a stop loss. With a drop of 1,000 pips, you can see what could happen to your $ 10,000 account. Let’s say you have a long position worth $ 100,000, leverage 100: 1, so the margin for this trade is $ 1,000. You still have $ 9,000 “non-margin” left.

GBP / USD down by 1,000 pips equates to your loss of $ 10,000, when you will get a margin call even before the price can fall further. This example not only shows the risks of using leverage, but also shows the need to use stop losses when trading.

Note about leverage in forex

Trading using high leverage increases your Forex trading costs. A position with a larger size will have a higher value per pip, which increases the transaction’s spread cost. For example, a 2-pip spread equals $ 20 of the cost of trading in a position of $ 100,000. Therefore, when planning your trade, you need to consider the transaction costs as well as the position size to make the right decision.

Summary

It can be said that leverage is a useful tool for traders to make money from the Forex market. However, this is also a risky tool especially for traders who are new to the trading market. I hope with the sharing in this article will help many investors have more knowledge about leverage as well as the content related to this tool. If you have any questions, please leave a comment below this article.

Leave a Reply

Your email address will not be published. Required fields are marked *