Forex trading is a form of speculation on the foreign exchange market. Leverage or margin trading enables traders to trade much larger volumes than they could using only their own funds alone, thus taking advantage of Forex’s rising popularity without risking all their capital.
Forex brokers offer leverage in the form of ratios which indicate how much buying power (leverage) you have over your deposit amount. For instance, if you deposit $1,000 and the broker offers 50:1 leverage ratio – that means for every $1 you put up towards buying positions, they will loan another $50 as funding to cover its cost.
As leverage can increase both profits and losses, it is imperative that a thorough risk management plan and using appropriate levels of leverage are established.
This article will introduce forex trading leverage, how it works, and its risks. Furthermore, we will cover strategies which can help traders to avoid potential pitfalls while making the most of this powerful tool.
Leverage in forex trading can help new traders quickly increase their profits if used properly, although this may not always be feasible since traders must still make a profit from their trades; otherwise they risk using more funds than are available to them and incurring unnecessary risks.
To better illustrate leverage, let’s look at an example from the forex market. Let’s say a trader wants to buy one standard lot of EUR/USD currency at its current rate of 1.2860; this would require investing $100,000. Most individuals cannot afford such an outlay of funds; however, by opening what is known as a margin account and depositing some portion of his or her investment there will be leverage available in a short amount of time.
Traders must post a security deposit as collateral against broker loans in order to use leverage trading to trade full value of currency pairs with leverage available. When currency prices move in their favor, their profits increase with leverage; conversely if prices move against them they experience losses equaling leveraged amount.
Many forex brokers provide leverage ratios ranging from 1:1 up to 100:1, giving even small traders access to the market and increasing profits. But those using too much leverage must use caution; too much can magnify both profits and losses exponentially. It is best practice for traders to stick to well-defined strategies that limit exposure while only risking small portions of funds on each trade, and use stops as part of a solid risk management plan in order to limit losses.