One of the peculiarities of the Forex market is the possibility of using what we usually call ‘leverage’. But what exactly is this leverage?
Now, the explanation that most brokers usually give about leverage is this: It is an instrument that will help us to make easy and fast money. While it may be true, there is something about leverage that is ‘almost’ never mentioned; how the leverage can be disastrous to an account if not deeply and clearly understood.
That is what we shall be looking at as we go further in this post.
Now, let’s start with a simple explanation of leverage:
What is leverage?
Leverage is a form of virtual credit, which allows us to negotiate in the market with the money of the broker. There are several leverage levels which typically range from 1:1 to 1:500.
Let’s say we have an account with € 1,000; if we use a 1:100 leverage, it is as if we had € 100,000 (1,000 x 100). This means that if a currency rises by 2%, we will earn 2% of 100,000 euros, that is, we will earn 2,000 € with an initial capital of only 1,000 €. The same principle applies if we lose.
Financial leverage means the use of external capital per unit of invested capital.
Why leverage is indispensable in forex trading:
Financial leverage is the only way for small investors to participate in a market that was originally intended only for banks and financial institutions. Leverage is a necessary feature in the Forex market not only because of the magnitude of the capital required to participate in it but also because the main currencies fluctuate on average less than 1% per day.
Without leverage, it would be very difficult to make profits, even if you have consistent investment capital.
The effect of leverage on a trading account
No doubt, leverage allows you to obtain more interesting profits in a short time, especially if you operate the shares with the CFDs.
However, the leverage effect also presents a risk that should not be ignored. In effect, while the profits are multiplied by the chosen coefficient of leverage, the same thing happens with the losses. So, a position with a leverage effect of 100 that loses a Euro will make you lose 100 Euros. Thus, it is necessary to have sufficient capital in the trading account to cover these possible losses and know how to stop them at the right time.
Let’s give a concrete example to illustrate this leverage:
Let’s suppose that you invest €100 as your capital on EUR/USD at 1.25 pips. Say at the time of closing this position; the cross EUR/USD has reached 1.26 pips. Without leverage, your profit can be calculated as follows:
100 x (1.26 – 1.25) = 1
You would only earn one euro in this transaction.
Now, suppose you engage in the same operation with a leverage of 1: 100. Your real investment is € 100, but you will speculate with € 10,000. Your profit will then be calculated as follows:
10,000 x (1.26 – 1.25) = 100
In this way, you will earn € 100 and not € 1.
Of course, the greater the leverage is, the higher the potential gains will be. But this advantage is double-edged since the number of your losses will also be multiplied by this same factor.
As we have just indicated, it is advisable to use leverage prudently and intelligently since your losses are also affected by this tool. So, with a leverage of 1: 100, the number of your losses will also be multiplied by 100.
If we look at our previous example and assume that EURUSD goes from 1.25 to 1.24 pips, you would then lose € 1 without leverage and € 100 with leverage. The bigger the leverage is, the more the risk of losing money. So, it is advisable to use minimal leverage to reduce the risks.
How to choose the right leverage to maximize profit and limit risks:
Now, we will end this post by looking at some tips that will help you use a leverage effect in the best possible way.
The leverage can be especially attractive to new traders who discover the world of Forex for their ability to multiply the potential gains tenfold. However, this is a tool that should be used prudently, especially about the choice of leverage that will be used.
Using leverage requires good management to limit the risks and not lose all of your capital because of a bad strategy. As far as Forex is concerned, I’d advise that you use only weak leverage effects, at least until you have fully mastered the market.
Before choosing which leverage to use for a specific asset, you must test both the volatility of this asset over time and your investment strategy. Current trading platforms provide interesting tools such as graphs that allow a historical analysis of the asset price or demonstration trading accounts in real market conditions that allow you to trade without risking your capital.
One of which is the Momentum Meter. This Expert Advisor (MT4 EA) will help you quickly see which currency you should be buying and which currency you should be selling. This EA is based upon the FX Propulsion strategy taught by yours truly. Feel free to check it out here.
My opinion on the ‘leverage’ in online trading
While the leverage remains a very interesting tool for investors who want to earn money online, it can pose an important risk to your capital not if used correctly.
Thus, I will advise traders who do not have much experience in the field of trading, and traders who foresee long-term positions to avoid using high leverage as much as possible.
Always remember what Voltaire said, “With great power comes great responsibility”. Leverage is a double-edged sword, and if not used wisely can spell doom on your trading account.
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