Leverage in Foreign Exchange Trading Explained
News | May 03, 2022, 9:41 AM | The content is supplied by a Guest author
Trading foreign currencies on the forex market is not reserved only for elite traders or licensed brokers. Anyone can buy and sell currencies, so long as they have internet access. Creating an account on a platform such as OANDA takes minutes, and understanding how to execute trades does not require much of a learning curve (trading itself, however, is anything but easy). The issue for some people is that they may not have significant funds to try their hand at trading currencies. That is where leverage comes into the picture. Even though it has many advantages, leverage can also be problematic for first-time traders. Below is an explanation of leverage in the forex market, and its pros and cons.
What is Leverage?
With respect to finance, leverage is using borrowed funds to increase a person’s trading position beyond the funds that are available to them at a given moment. If we are assessing the forex market, leverage refers to extra money that a user can put into trades, aside from the money that is in their account. Many forex platforms, even the most reputable ones, offer leverage to consumers who are hoping to trade currency pairs.
Leverage allows a person to trade on margin, which means they are trading beyond the capability of their investment account balance. A person who only has $500 in their forex account, for instance, could use leverage to perform margin trades of as much as $5,000.
Various institutions within the forex market have different requirements for margin for their users. They are likely to have more relaxed requirements for long-time or high volume users, who they know are frequent traders that can be trusted to trade responsibly on margin.
If a person creates an account at a forex platform and deposits $100, they are likely to have more restrictive margin rules. The platform, for instance, could indicate the user has to deposit at least 10% of the total value of a transaction they are performing on the forex market.
Say you are thinking about investing $10,000 in a currency pair, but you do not have that much money in your account, you would have to put down $1,000 as a deposit with the forex platform to complete such a trade. Then you can perform your trade for a value of up to $10,000, based on your margin requirement.
Benefits of Margin Trading
The advantages of margin trading are evident for both small-time and big-money investors. Whether you are trading forex casually for a couple of hours a week, or you are trading as a full-time job, leverage and margin trading allow you to go beyond your bank balance.
Rather than having to put all your savings into a few trades, or borrowing money from other institutions to add those funds into your forex account, you can trade on margin. Having access to such leverage allows you to buy and sell greater quantities of currencies, potentially giving you more profit on each trade.
Even if you trade on margin, you are receiving the entire profit of the trade when it completes. That is why access to leverage is so potentially advantageous for forex traders.
Drawbacks of Leverage in Forex
The one negative of having access to leverage on your forex account is that you can get carried away. There are cases of first-time traders using the maximum leverage available on their account to execute a trade, only to lose a lot of money on that transaction.
Say you have $100 in your account and are allowed to invest up to $1,000 on a trade. If you were to lose 20% of the value on that trade, then you would be down $200, which is more than you added to your forex account.
Trade Sensibly on the Forex Market
One of the ways that people can make mistakes when they are trading forex is to use too much leverage. The idea of buying currency combinations with a value of 100 times what is in your account is tempting, but you are creating a potentially dangerous situation.
If you make a mistake with your trades, and the currency combination you buy loses a lot of value, you may end up owing more money than you have in your account. That is why you must trade sensibly, and only use leverage when you have many months of experience as a forex trader.