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Friday, August 3, 2012

Leverage in Forex

Leverage in Forex allows increasing the power of trading accounts by literally allowing traders to operate larger funds. For each real dollar funded by a trader, Forex brokers offer a leverage up to 400:1 or even higher, which increases traders buying/selling capabilities while trading Forex.

A leverage of 200:1, for example, means that for each dollar invested a broker adds $200 dollars on top, making the trading account 200 times larger. Thus, funding your account with $1000 at 200:1 leverage would enable you to operate a  $200 000 account.

Only traders with really large accounts may afford trading Forex without leverage. For all other traders leveraging their investments is often the only way to participate in Forex currency trading and be able to operate large trading lots while  make reasonable profits from trading Forex.

What leverage does, it allows a trader to trade money he/she doesn't possess. We may call it virtual money trading.

While it is possible to make profits with virtual money in Forex, it is absolutely impossible to lose virtual money, instead traders lose only real money they have invested or earned as a result of profitable trading.

Forex brokers offer various leverage options: from 10:1 up to 500:1 Forex leverage know today.

While experienced traders have no problems choosing the next best leverage for their new trading accounts, novice traders often have difficulties selecting the right leveraging option. Besides that, warnings about dangers of high leverages published online by Forex traders create additional fears.

There is danger in almost everything if one doesn't know how to use it.

High leverage can be dangerous IF a trader doesn't have the basic knowledge about using it properly. That's right, a basic knowledge about leverage is just enough to keep any Forex trader away from troubles and actually stop worrying about  this subject at all.

Let's learn those basics:
  • Leverage enables any trader to be an equal participant on the Forex market alongside with large institutional traders, such as banks, various financial institutions and individuals with large trading accounts;
  • Leverage allows trading larger positions, e.g. operate larger funds;
  • The higher the leverage the higher trader's buying/selling capability at any moment;
  • The higher the leverage the lower the margin requirements
"What leverage does, it allows a trader to trade money he/she doesn't possess. We may call it virtual money trading. "

and

"While making profits with virtual money is possible, it is absolutely impossible to lose virtual money, instead traders lose only real money they have invested or earned as a result of profitable trading."

Let's take an example.
Invested capital = $1000 USD.
Leverage 200:1
Buying/selling capability = $1000 * 200 = $200 000

This enables a trader to buy/sell a regular trading lot size of 100 000 units, which looks good and feels good (when thinking about potential profits). But is it safe?

Leverage allows to trade larger positions in the market. Larger positions mean larger profits when a trader wins a trade, but also larger losses if a trader was wrong about the market direction. In our case (with 100 000 units lot size) each pip a trader earns brings him $10 profit, but each pip he loses cost him -$10.

What concerns us is the Loss question. So let's focus on the simple math.
A normal situation: the market moves -20 pips against our trader.
20 pips * $10 = -$200 USD

Those $200 dollars will be subtracted from initial $1000 account balance, which will bring it down to $800. (Buying/selling capability will now match $800 * 200 = $160 000)

What we actually have is that 1/5 of the trader's initial investment has been lost in a single trade(!) — a trade where conditions were moderate, e.g. losing 20 pips is not a big deal in currency trading; traders on average lose 35-50 pips on each trade. No need to mention that in two consecutive losing trades of -50 pips each, our trader would lose his/her entire account, it is so quick!
  • 50pips * $10 = -$500
  • $500 * 2 times = -$1000
That's why you hear traders calling a high leverage "Leverage the killer".

The conclusion is: one cannot trade with large virtual money having invested little real money. A highly leveraged account and a high buying/selling capability doesn't mean one should be trading away with large trading lots.

In our case, having invested $1000 USD no matter at what leverage, a trader can only trade reasonably with a lot size of 10 000 units (or less) where each pip would cost $1 (or less). Hence, losing 20 pips would mean losing only $20 on one trade. 

We advise trading with a pip value smaller or equal to $1 for accounts smaller than $1000 USD.
(1 pip on average equals $1 when trader open 1 lot of 10 000 units)

If we cannot use our buying/selling capability provided by a leveraged account, how can we use leverage then? What difference would it make if we take lower or higher leverage?

We need a higher leverage to have a lower margin.

Stay tuned for margin in forex.


Cheers!

1 comment:

Blogger said...

I recommend that you stick with the best Forex broker.