Forex trading involves various elements that add to the success or failure of a forex trader. Leverage is one such element that can either make you earn higher returns or incur severe losses. Since the forex market carries high volatility and risk exposure, excessive leverage can wipe off your account in no time. In this article, we explain the best ways to use leverage in forex trading.
What Is Leverage?
Leverage is borrowed money that brokers offer to their clients, allowing them to trade higher volume with a smaller investment. Traders only need to fund their accounts with a fractional amount. The ratio between the investment required and the value of a position is called leverage. Trading with leverage is also known as margin-based trading.
Best Ways to Use Leverage in Forex Trading
Given below are some best ways to use leverage in forex trading;
1) Choose appropriate leverage
Careful selection of leverage is vital in forex trading. Trading high volumes doesn’t necessarily mean higher returns. You need to follow a well-planned trading strategy instead. It is good to always decide the maximum amount you can afford to lose before availing leverage. Considering the associated risk, regulated brokers do not usually offer leverage of more than 1:30. However, some regulated and many unregulated brokers may offer leverage up to 1:2000 or even more.
2) Lot size matters
In leverage trading, the size of a lot also matters. For example, with a $1000 balance in your trading account, you want to open a position on EUR/USD whose market value is 1.1920. If the price of the EUR/USD pair moves to 1.1930, then it means the price has moved by “10” pips. With a standard lot, “10 pips” represent $100 profit or loss. Using higher leverage, you might open even 20 lots with your available investment margin, resulting in a total profit/loss of $2000 in just one trade as discussed in the aforementioned example. Imagine what can be even worse than having a loss that exceeds your initial investment by $1000. On the other hand, if you select a mini lot, you risk a maximum of $20 on each position.
3) Use limit stops or trailing stops
In a fast-moving market, the use of leverage can be disastrous. Using limit or trailing stops may help traders to reduce their risk exposure. With limit stops in place, a trader can open leveraged positions confidently. A limit stop closes the open position if the market moves against your desired direction beyond a specific level. On the other hand, trailing stops help traders to quit trading in highly volatile market conditions. A trader may optimize profitability with the help of trailing stops.
4) Broker selection
The selection of a broker is as significant as choosing an appropriate leverage ratio. A broker offering fast trade execution may have reduced slippage than the ones with poor latency. Slippage is a popular trading terminology. Slippage represents the difference between the expected and executed price of an order. Similar to high market volatility, the slippage can also be detrimental for a leveraged position. Even a slight level of slippage, missing the defined stop loss, is enough to get you in a lot of trouble. Similarly, a dishonest broker might have stop-loss hunting tools in place, which could result in some serious losses with margin-based trading.
5) Effective risk management
Leverage is not the only factor responsible for losses. It could also be a poor risk management strategy that adds to your failure. With an effective risk management approach, you can reduce the risk exposure despite using higher leverage. Let me explain it with an example;
Suppose John and Stuart have $10,000 in their trading accounts. John opens a position worth $2000 using a leverage of 1:20. John’s initial margin is $100. If John incorporates a stop-loss of 2.5% away from the point of entry, then his risk exposure is limited to $50 in case the market moves against him. In percentage terms, John’s risk exposure is only 0.5% of his total investment.
On the other hand, Stuart selects a leverage of 1:50 and opens a position with a margin of $5000. He could control a position worth $25,000 with a margin of $5000. In case the market moves against him, the risk of loss could be as high as $625 that is equal to 6.25% of his capital investment.
That means John manages risk more effectively as compared to Stuart. Despite incorporating high leverage John’s risk exposure is way less than Stuart’s.
Leverage Trading – FAQs
What does buying power mean in leverage trading?
The amount which is greater than the account balance of a trader to trade a particular financial asset is called buying power. The use of leverage is directly proportional to buying power.
What is coverage in leverage trading?
Coverage is a fundamental indicator that traders should never forget in any case. It is a ratio of the net account balance with respect to the leveraged amount. In short, coverage represents the money required to trade a specific asset. It is also known as margin.
What is a margin call in leverage trading?
In case the risk ratio or coverage falls below the minimum level to hold a leveraged position, an investor receives a warning from the broker, that warning is known as a margin call. Traders must increase margin by depositing fresh funds or close the existing positions upon receiving a margin call from the broker.
Is it good to use higher leverage?
The answer to this question depends on your competency to handle higher leverage. Having an option to use higher leverage should not be the only reason for using it. If you take higher leverage, then plan it well before it’s too late. Adopt an effective money management approach if you plan to use higher leverage. For example, using higher leverage you can trade mini lots with an initial investment of $10,000. In such a scenario, each position would result in a risk of less than 10% of your investment and each pip would be worth as low as 0.1 USD.
Leverage is a crucial element in forex trading. While it enables clients to maximize their returns, it also magnifies the risk of loss. However, by following the best ways to use leverage, traders may find leverage a worthwhile opportunity to enhance their profitability.