In this article, I will be discussing what is leverage in forex for beginners, how leverage works, and what leverage mistakes can wipe out your forex account. But first, what is Leverage?
The dictionary definition of “leverage” is the ability to control a large sum of money while using little or no capital of your own, while completely borrowing the rest. The ratio of the amount used in a transaction to the required deposit is referred to as leverage.
It is the percentage or fractional increase you can trade from your available capital. It enables traders to trade notional values far above their available capital.
Leverage of 100:1 implies that you can trade a notional value that is 100 times greater than the initial capital in your trading account.
How Does Leverage Work?
Before I share some tips on leverage in forex for beginners, I need you to understand how easy and difficult leveraging can be.
To control a $100,000 position, for example, your broker will deduct $1,000 from your account. Your leverage, measured in ratios, is now 100:1. With $1,000, you now have control of $100,000.
Assume your $100,000 investment increases in value to $101,000 or $1,000. If you had to put up the entire $100,000 yourself, your return would be a meager 1% ($1,000 gain / $100,000 initial investment).
This is also known as 1:1 leverage which is misleading. Because where is the leverage in having to come up with the entire amount you’re attempting to control? Fortunately, you can leverage 100:1.
Because the broker’s cut is $1,000, your return is a whopping 100% ($1,000 gain / $1,000 initial investment). We’d like you to do a quick exercise now. Determine your return if you were to lose $1,000.
If you calculated it the same way I did, which is also known as the correct way, you would have gotten a 1% return with 1:1 leverage and a 100% return with 100:1 leverage.
Do you see how leverage works now? It magnifies the movement in the relative prices of a currency pair in your account.
The Power of Leverage in Forex
You’ve probably heard phrases like “leverage is a two-edged sword” or “leverage is a two-way street.” As you can see, these clichés were not deceptive.
Most new traders underestimate the potentially catastrophic damage leverage can inflict on their accounts. Understanding leverage well enough to know when and when not to use it is critical to your success!
Leverage is a very powerful tool, but most traders (old and new) use it to squander their trading capital, simply because they underestimate it.
It’s unfortunate, but the more of them there are, the easier it is for us savvy traders to profit. In any case, high leverage is a popular selling point for the majority of forex brokers.
Yes, they pitch that massive leverage to help you make a lot of money, but they also know that massive leverage can easily reap you off. Most forex brokers just want you to trade in the short term.
They want you to trade as much and as frequently as possible. It’s the only way to make their money, so they care about one or two pips.
The more trades you make, the more money these forex brokers make on the spread. It is not in their best interests to advise you to keep your trades open for longer than one day.
Leverage is Not Magic!
If you want to give yourself the best chance of success, you should first learn to trade profitably without the use of leverage. We all agree that leverage is a good thing but remember to exercise caution and play it safe to protect your capital.
The fact that you can consistently make more pips than you lose, doesn’t mean that you should abuse the power of leverage. Don’t believe that because brokers allow you to use high leverage with a low minimum deposit, you can “make a quick buck” or “get rich quick.”
Forex is a serious business, and you must approach the currency markets with caution. Your expectations should be realistic, and you should be willing to educate yourself.
If you break the laws of leverage, you will not only lose money but your account will also be terminated.
Common Leverage Mistakes: Why Most New Forex Traders Fail
Now that you have understood how to use Leverage in Forex For Beginners, the next step is to take note of some common mistakes that both old and new traders make when using leverage.
For every $50,000 in their account, most professional forex traders and money managers trade one standard lot. If they traded a mini account, they would trade only one mini lot for every $5,000 in their account.
So why do inexperienced forex traders believe they can make a profit by trading 10,000 mini lots with $250 or 100,000 standard lots with a $2,000 account?
Whatever the forex brokers tell you, never open a “standard account” with less than $2,000 or a “mini account” with less than $250.
Some even allow you to open accounts with as little as $25! The most common reason new traders fail is that they are undercapitalized from the start and do not understand how leverage works.
Don’t put yourself in a position to fail. Before opening a standard account, I recommend that you have at least $100,000 in trading capital, $1,000 for a micro account, and $10,000 for a mini account.
Of course, only open an account if you are consistently good. If you have less than $1,000, just open a demo account and stick with it until you have the money to open a micro account.
Find a job if you only have $1. The fact that brokers allow you to open an account with as little as $25 does not imply that you should.
In my opinion, most new traders who open a forex trading account with the smallest deposit do so because they don’t fully understand what the terms “leverage” and “margin” mean and how they affect their trading.
You must be fully aware of the significance of trading with leverage. I can guarantee that if you don’t have a firm grasp on leverage and margin, you will lose your trading account!
Frequently Asked Questions
What Leverage in Forex for Beginners Should I Use?
The best forex leverage ratio is generally agreed to be 1:100 to 1:200. With the leverage of 1:100, the trader has $50,000 of credit funds provided by the broker to open trades with $500 in the account. As a result, the best leverage to use in forex trading is 1:100. July 31, 2020
Do You Have To Pay Back Forex Leverage?
Forex leverage differs from a credit line in that it does not have to be repaid. It functions as a safeguard to ensure that you do not default on your positions. As a result, you must keep your position open until a margin call closes it. As a result, when you use leverage, you owe nothing to your broker.
Is It Possible To Trade Forex With Leverage?
Leverage is frequently used by forex traders to profit from relatively small price changes in currency pairs. In contrast, leverage has the power to amplify both profits and losses.
What Effect Does Leverage Have On Forex?
Leverage refers to the amount of money available to you as a result of borrowing investment capital. The more leveraged you are, the riskier your position—a few pips loss could mean losing all of your money.
Does Leverage Widen The Spread?
Leverage magnifies both your losses and your transaction costs as a percentage of your account. Assume you open a $500 mini account. You purchase five mini $10,000 lots of GBP/USD with a 5 pip spread. As your account balance decreases, your leverage rises.
Do You Lose Money When You Use Leverage?
In essence, leveraging allows you to use borrowed funds to invest more money, thereby amplifying your results. Because you can increase the total value of what you own, a larger gain will improve your input, whereas a decrease in value will result in a larger loss.
I hope this article on leverage has given you some insights on what is leverage in forex for beginners, how to use the power of leverage to your advantage, and how to avoid common mistakes. Here’s a summary of what we talked about:
In forex trading, leverage, or the use of borrowed money to invest, is very common. Investors can trade larger positions in a currency by borrowing money from a broker.
However, leverage can be a two-edged sword in that it can magnify losses. Many forex brokers require a percentage of the trade money as collateral, which can be higher depending on the currency.