How to choose your forex leverage wisely?
Leverage in forex trading often brings out curiosity and excitement for traders and is in fact one of the most hyped word in forex trading. Beginners to forex don’t really know how leverage works and usually end up selecting a leverage of 1:200 and upwards.
Of course, as forex brokers tend to offer leverage as high as 1:1000 it is indeed a fact that most traders do not really give it much thought and end up selecting their forex leverage based on gut feel or the feel good factor.
So 1:100 or 1:1000? Heck, 1:50 what is leverage in forex and how to choose your ideal leverage. Read this article to know more.
What Is Leverage in Forex trading?
Let’s first begin by explaining the concept of leverage in forex. The concept of leverage is that you borrow some money in order to invest.
From a forex perspective, leverage is the amount you borrow from your forex broker in order to trade the instruments.
Most forex brokers offer leverage from 1:1 and can go as high as 1:1000. Well, the broker is not misleading you by offering such leverage. In fact when you use high leverage for an initial margin requirement you can immediately build up a huge pot of money.
It is perhaps for this reason alone, traders tend to make use of high leverage rather than sticking to a more realistic leverage.
What leverage are you on?
If you are reading this article a bit too late and you are currently trading, you can calculate your current leverage.
To determine your leverage, divide the total value of your opened positions by your trading capital.
Or consider this example. Your account balance is $5000, whereas your open position are $100,000 (or 1 lot), which brings your leverage to 20 times (100,000/5,000). And if you trade 2 lots or $200,000, then your leverage increases to 40 times and so on.
Is Leverage really that important in Forex?
In forex trading, price movements are measured in Pips, the small change in the currency pair’s price. The Pip value is usually the fourth or fifth decimal point that changes.
If you look at an exchange rate at face value, there is little to none movement because of the minute fraction of the cents movement. And if you were to trade in actual pips, the profits you make are almost negligible. It is for this reason that leverage is used in forex so as to increase the amount you trade which is then translated to a profit that can be considered to be decent.
To put it in perspective, if you were to trade 1 lot, or $100,000 then fractional pip movements now amount to something more substantial than just profiting in cents.
Forex brokers usually leave the choice up to the trader as to what leverage they can choose.
Higher Leverage = Higher Risks
With ECN forex brokers, leverage is usually limited to not more than 1:300 because of the fast price movements and market volatility. A trade that goes against you in a few minutes can prove to be highly disastrous if you were trading with a 1:800 leverage for example.
It is often said that leverage can be your friend or can be your worst enemy, depending on which side of the trade you are. Leverage in forex has the potential to magnify your profits while at the same time magnify your losses as well.
Most forex brokers require on average a minimum of 1% deposit margin. So depending on the amount of leverage you are using, if the trade goes against you, your losses are also magnified in the same proportion.
Many forex traders that use high leverage without a good risk management strategy often end up losing all their balance in just a single trade.
Setting up stop losses when using high leverage alongside a trading strategy can help you gain big profits while minimizing your risks. But such kind of high leverage trading requires technical skills.
Most beginners often focus on the profits one can make from using high leverage, whereas experienced traders stay away from using high leverage as the potential losses clearly indicates the level of risk they are getting into.
While forex brokers offer high leverage, the onus is on the trader to choose a leverage that they can manage to trade with.
Why do forex brokers offer high leverage?
There are a number of reasons why a forex broker offers high leverage. Whatever the reasons may be, one of the common reasons is because a higher leverage attracts the gullible trader.
Traders end up trading with high leverage and with just $100 and hope that they can make a quick buck. Unfortunately, the high leverage is a ticking time bomb that is waiting to bankrupt the trader sooner than later.
This is why many professional forex brokers such as LMAX Exchange do not encourage leverage of more than 1:200.
In the United States, leverage is set to no more than 1:50.
Choosing your leverage wisely- Conclusion
When you use a reasonable amount of leverage on your trades, it allows you the flexibility to set up a wider stop loss. On the contrary, using a higher leverage on your trade can very quickly eat up into your margin making you losing more that what you intended to.
In other words, higher leverage would reduce the flexibility on the stop losses thus giving you a very small window of profit.
Leverage is flexible and is often customizable to your trading requirements. To draw a parallel, leverage could be compared to Credit cards. You know that you have access to additional borrowing, but it comes at a cost. Just because leverage is available doesn’t mean you must use it. Always consider the worst case scenario before you take the plunge.