The foreign exchange market, or forex, is the world’s largest financial market. It stands out due to its high liquidity and uninterrupted trading sessions across different global regions. One feature that sets the FX market apart is the concept of leverage.
Leverage is using a broker’s money to enter a large transaction. While many people have heard the standard definition of leverage, few know what it actually is and how it can impact their growth. If you’re wondering what is forex leverage, keep on reading.
What is Leverage in FX Trading?
Leverage in the foreign exchange market is a tool that allows traders to control positions that exceed their capital investment. Think of it as borrowing funds from a broker to amplify potential gains.
Leverage works when a trader deposits a small percentage of the total trade value as margin, which gives traders an augmented exposure to an underlying asset. In simple words, traders are only required to commit to a fraction of the full trade’s value. The rest is covered by capital provided by the broker.
Types of Leverage Ratio
The borrowed funds are represented as a leverage ratio, such as 10:1, meaning a trader can control 10 times their deposit. Types of leverage ratios include:
Low leverage (1:1 to 20:1) – This ratio ensures a conservative approach to forex trading, where traders can seek minimal exposure.
Moderate leverage (30:1 to 50:1) – This is common among retail traders and swing traders who hold their positions for several days.
High leverage (100:1 to 200:1) – With 100:1 leverage, $1,000 controls $100,000 in currency. High leverage ratios are recommended for experienced traders.
Extreme leverage (400:1 to 1000:1) – This ensures maximum position control, primarily chosen by offshore brokers and professional traders.
Risk of Excessive Leverage
Leverage is a double-edged sword. It gives you the potential to not only enlarge your profits but also losses. Even a small percentage decrease in the value of an asset can result in significant losses.
Moreover, leverage also increases the risk of margin calls. As a result, you will be at risk of losing positions. If you fail to respond to a margin call within the time limit specified by the broker, your broker can sell your positions to cover their capital losses.
Always use stop-loss orders and monitor your account to avoid facing a margin call.
How to Use Leverage Wisely
There are numerous strategies you can follow to gain benefits from leverage. Here are some examples:
- Always use lower leverage ratios. Beginners are recommended to start at conservative ratios, such as 10:1 or 20:1.
- Implement stop-loss orders, where brokers automatically close a position when the market reaches a certain price level.
- Diversify your trades to limit exposure.
- Monitor margin levels closely to avoid losing your positions.
- Practice with demo accounts to familiarize yourself.
By using leverage wisely, you can avoid falling into common pitfalls and earn larger profits.
