What is leverage trading?
Leverage trading implies that you boost the amount of risk you’re able to take with a given margin deposit to set up a bigger trading position. The more the amount of leverage ratio you have the greater would be the trading position you’d be able to have in your margin account. Visit MultiBank Group
Do bear in mind that the higher the trading leverage you use for your positions, the higher would be the risk. For instance, a $100 initial deposit could quickly disappear because of the slightest adverse move in the forex pair with an incredibly high amount of leverage. Using the same token, should the market move in your favor, your profits will rise by the amount of leverage you have for your position.
Leverage in forex trading
In the foreign exchange markets, typically leverage could be as much as 100:1. It implies that for every $1,000 that you hold in your account, you would be able to trade up to $100,000. Several traders are of the opinion that forex market makers are able to provide high leverage but it is a risk function. They’re aware that if the account is well managed, the risk could also be mitigated, or else the leverage would not be offered. Also, given the fact that the spot cash forex markets tend to be big as well as liquid, entering and exiting a trade at the expected levels would turn out to be simpler than other markets that are relatively less liquid markets.
In trading, the currency movements are noted in pips, which refers to the smallest change in currency price and is also reliant on the currency pair. These movements are simply fractions of a cent. For instance, if a currency pair such as the GBP/USD shifts 100 pips from 1.9500 to 1.9600—it is essentially a single cent move of the exchange rate.
This is the reason why currency transactions need to be carried out in sizable amounts which make room for such minute price movements to be worked into bigger profits when boosted using leverage. When you’re working with a large amount like $100,000, because of the slightest changes in the currency price, the overall profits or losses could be heavily affected.
Leverage vs. Margin
Leverage establishes the amount required to deposit with your broker so you’re able to maintain a certain forex trading position, whereas margin refers to how much money you finally end up depositing with your online broker. Essentially, the margin is used to create leverage.
Leverage is typically expressed as a ratio of the sum of a trading position that you could control with a base currency unit. This ratio is indicated as X:1 where X refers to the amount of a position you’re able to manage with a single unit of your base currency. Let’s say that your base currency is U.S. dollars while your leverage ratio is 100:1. This would imply that you’d be able to manage a $100,000 trading position with simply a margin of $1,000 as a deposit.
Contrary to the leverage ratio, the margin requirement of a certain position is generally indicated as a percentage. Leverage and the margin requirement have an inverse relationship which could be seen as follows:
Leverage = 1 / Margin Requirement
If you’d choose to work with a leverage ratio of 100:1 at your broker, the margin you need would then be:
100 = 1 / Margin Requirement
Margin Requirement = 1/100 = 0.01 = 1.0%
You may want to calculate how much of the position you’re able to control with a given amount of “necessary margin” or how much money you should deposit. You can do this with the help of this equation to calculate the position size you could control:
Controllable Position Size = Required Margin / Margin Requirement
With the help of the last example of a 1% or 0.01 margin requirement and a necessary margin amount of $1,000 is replaced with the above equation, you’ll have:
$100,000 = $1,000 / 0.01
The outcome implies that you’d be able to manage a position size of $100,000 should you add $1,000 as margin aiming at a margin requirement of 1%.
Pros of Leverage in Forex Trading
Working with leverage as you trade various currencies has some advantages such as:
Increased Profits
The key advantage of working with leverage trading in forex is that you’d be able to manage a position that is much bigger than the amount of money you’d deposit with your broker. Should your trades be profitable, which may not always be the case–your profits may be more than the traders who do not have a leveraged position.
Boosts Capital Efficiency
You could work with your existing trading capital in a better way by using leverage as you’d be able to manage larger trading positions with a particular amount of capital used as a margin deposit. With this, you’ll be able to get started in forex trading with a small sum of money.
Combats Low Volatility
The forex market shows comparatively less volatile behavior than various other financial markets such as the stock market. Leverage allows you to boost the impact of movements which take place on your trading results.
Cons of Leverage in Forex Trading
Using leverage in currency trading comes with certain disadvantages as well:
Potential for Heavy Losses
Your losses could be amplified depending upon how much leverage you use. In such a case your trading account could be blown away in no time, so you must use leverage wisely.
Constant Liability
Leverage includes a continuous liability because all leveraged profits as well as losses have to be paid off to ensure that you’re able to continue trading once your position is closed out.
Increase Risk of Closeouts or Margin Calls
The use of leverage implies that you are prone to the risk of an automatic closeout of your losing trading positions. Your broker may either close the positions or send you a margin call in case the net value of your forex trading positions drops further below your margin account’s balance.