Most forex trading brokers usually go out of their way to lend funds to traders, allowing them to grow their investments. The traders have a free hand on how far they can go with minimal amounts of capital.
Sometimes leverage in forex trading works quite well; other times it can leave your business simply gasping for breath. All we can say is that it can be a two-edged sword.
However, if you properly apply certain money management rules, you can quickly avoid any amount of risks, acquire huge amounts of money, and increase your return on investment.
What Is Leverage and How Does It Work?
It involves traders borrowing money from their respective brokers so as to increase their profit margin. The fact that traders have this advantage at their disposal is what makes the whole concept of forex trading popular.
For any broker to use leverage, there needs to be minimum deposit in a trader’s account which is usually referred to as a margin. Using an initial margin requirement, a suave trade can build up their investments to higher scales.
There is a simple formula that is used to calculate an initial margin. You just divide the total transaction value with the amount you are required to top with.
Here is a perfect example; you are asked to deposit 1% of the total transaction value as margin. Your intention is to trade using one standard lot usually equivalent to $1000 000. In this case, the margin lot required is $1,000.
You simply divide (100,000/1,000) which represents a ratio of 100:1. This formula can be applied to any other margin requirements to allow you to come up with margin-based leverage.
How Leverage Affects Forex Trading
Basically, any margin-based leverage is only comparable to the maximum amount of leverage any trader can use. But what you must also be aware of is that real leverage can sometimes differ especially if a trader is not using their entire account as margin for each of their transactions.
The most experienced trader knows how it’s important not to use all their margins which are available at that moment. You can only do so when you know that the risks are almost down to zero.
For example, a trader can easily determine any potential loss of funds by associating the amount of risk that comes with amounts of available pips. The general rule is that any loss should never be beyond 3% of trading capital.
Also, the leverage needs to be considerably cut down if the potential loss is being predicted to be much higher based on a trading account.
A trader who is just starting can be in the dark, not knowing the exact leverage risks that abound. An example is if you decide to use all the available leverage without considering the amount of money in your account. Simply put, unabated leverage can wipe out your trading account in an instant.
You also need to take into consideration the fact that the higher leverage you take, the higher the transaction costs. So when you are choosing a broker, one of the most important things you need to look into is how much are the transaction charges for your trading capital.
Can You Limit The Risk?
The answer is a big yes. You can apply various risk management rules and techniques to eliminate the risks. For example;
- You need to be fully aware and prepared for any risks that come with leverage.
- You then need to consider how much you can risk without having to burn your fingers.
- Check also the amount that is charged as transaction costs. It allows going for only that which you can afford when it comes to leverage.
- Apply the stop order rule which allows you to move stops so that you can break even.
It is always necessary to calculate risk based on what is available in your trader's account. Unabated borrowing can easily eat into your trading account to its negatives.
Basically, the only funds that you can afford to speculate is that kind of money that represents the kind of risk you are ready for. These are the funds that you can afford to lose without compromising your business, and overall financial standing.