New traders often start with trading accounts that are smaller in size so as to familiarize themselves with the market, develop trading strategies, and get some experience. However, small accounts that have just a couple of hundred dollars don not enable you our profits. Most often they impede your ability to succeed as a forex trader. In the forex market, the relative prices of currency pairs do not fluctuate a lot every day and you might start feeling that you are not getting anywhere in spite of bagging a few wins in a row. This is because the currency price fluctuation is less than 1 percent in the forex market on a normal trading day. On a particular day, if there is any significant news or economic data releases the market may turn volatile and witness large price fluctuations.
Fortunately, there is a way in which you can increase your earnings from successful trades. It is by making use of the leverage option. The aim of this article is to give you a clear idea as to what leverage means and how you can use it to your advantage. A thorough understanding of leverage is essential to improve your earnings and return on investment.
Leverage – What Is It? How Does It Work?
Leverage enables you to open a larger position than that allowed by the balance in your trading account. Basically, the forex broker you are working with is advancing you money to open a position of larger size, considering a portion of your account balance as collateral security for the trade. The broker will return the collateral, referred to as the margin, once you close the leveraged position.
Brokers provide you with the leverage facility because most of them have special arrangements with investment banks and financial institutions for lending money to them. It is this money that they lend to you as leverage. At this juncture, you must keep in mind the fact that the spreads, broker’s profit, will widen when you open a position of larger size. As a result, leverage which has the potential to enhance your profits can also multiply your losses. That is why you have to exercise a great deal of caution when using leverage in your trades.
Till now, we have been discussing as to what leverage means. In Forex trading, you have the freedom to choose the leverage you desire. Typically, forex brokers offer a range of leverage ratios starting from 10:1 to 100:1, or even higher, depending on the applicable regulatory restrictions. As such, your position size depends on the leverage offered.
If your trading account size is $1,000 and you choose a 100:1 leverage, it means that the maximum position size you can take is $1,000 X 100 = $100,000. You have only $1,000 with you, but you can buy positions worth up to $100,000. On the basis of the leverage chosen by you, your broker will set apart a part of the amount in your trading account as collateral security for a trade. This is referred to as the margin. The margin that you have to keep aside depends on the leverage ratio chosen by you. The margin requirement will be higher at lower leverage ratios and lower at higher leverage ratios.
Your broker will automatically implement this. You need not take the trouble to calculate the margin at all. When your trade hits the targeted profit level or you decide to close your position manually, the margin amount will automatically be returned to your forex trading account.
Forex Leverage Example
Now that you have a fair idea as to what leverage is, let us try to understand as to how it works to your advantage by way of an example. Imagine that the size of your trading account is $1,000.
The size of the position that you can buy without leverage will be limited by the balance available in your trading account. In this example, it is $1,000. In the currency market, the position size of a standard lot is 100,000 units. This means that $1,000 amounts to a micro lot. Typically, a move of one pip on a standard lot indicates a profit or loss of $10. This, in turn, means that a one pip move on a micro lot results in profit or loss of $0.10 or 10 cents.
Imagine that you have taken a long position on the EUR/USD pair and that the pair moves 100 pips up. Without leverage, your total profit will be approximately $10 (100 pips X $0.10) or 1 percent of the size of your trading account. As most forex pairs do not generally move more than 1 percent in a day, it is a challenging task for you to expand your trading account when leverage cannot be applied. This is the case even if most of your trades are winning trades.
Now, imagine that your broker offers you 100:1 leverage. With this leverage, the total size of the position you can take is $100,000. This means that you can buy a standard lot. In this scenario, a 100-pip move will represent a profit or loss of approximately $1,000 or 100 percent of the size of your trading account. This is why many traders find the leverage option to be very attractive.
All said and done, one important aspect that you have to keep in mind is that your entire account balance of $1,000 will be set apart as the margin for your trade. Therefore, you will have a problem if the trade happens to go against you by just one pip. Your trading account will fall below the specified margin and lead to a “margin call”.
As such, a more sensible decision would be to invest just $100 in a particular trade. This means that you have to set apart only $100 as margin money but take a position size of $10,000. The balance of $900 in your account would be there to cover a negative price fluctuation. You will still make a decent profit, but the risk involved will be very less.
Summarizing, a clear understanding of what leverage is and how it works is crucial for your success as a forex trader. Further, it is also important to keep in mind that leverage is helpful in growing profits, but it can multiply your losses as well.