A lot of Forex brokers offer trading volumes much larger than the actual capital their clients can afford. In other words, traders borrow money from their brokers to engage in large-volume trades. In this way, traders can place orders as big as 100,000 units of a currency against 1,000 units of equity in their account; i.e., Financial Leverage.
Using leverage requires a certain amount of money as a security deposit, aka Margin. The amount of money required as a margin depends on the selected leverage rate.
When the trades succeed, the traders will receive their profits and the burrowed money will return to the brokerbroker. On the other hand, when the trades fail, the amount of loss will be taken from the account margin to return the borrowed money to the company.
Leverage is a loan from the forex broker to the traders to control large volumes and increase profits. After closing the trade, the borrowed money should return to the forex broker in full.
So, let's say Trader A has only $1,000 in his account and wants to trade the EUR/USD currency pair. He can only place one mini lot of 1,000 units of account balance but would like to place a standard lot instead, or 100,000 units. Therefore, he needs an additional amount of 99,000 USD to be able to do that. The extra will be provided by using leverage.
The leverage needed by Trader A to start trading is calculated as follows:
Trader A then starts trading 1 standard lot using 1:100 leverage and has a margin of $1,000. After completing the trade, Trader A receives 0.0010 profit or 10 pips.
Trader A’s profit goes directly to his trading account. Then, the leveraged amount is returned to the broker in full. Now Trader A has a balance of 1000 USD.
Conversely, when Trader A loses 10 pips after closing a trade, $100 will be taken from his account. The broker still receives the full amount. Thus, Trader A has a balance of $900.
Different Forex brokers offer different leverage amounts based on the needs and level of trading of their clients. For example, if you have $1,000 in your account and use it as a margin, based on the amount of leverage, the reach of your trading capital will be as follows:
Leverage trading offers the following benefits to traders:
1. Increased Potential Profit
You can gain more profits with your current capital but the help of leverage.
2. Increased Capital Efficiency
Through leveraged trading, you can achieve more profits by spending less time. In the example above, it takes you 50 winning trades to get a $5 profit without leverage. Whereas, leveraged trading enables you to get up to $5 profit in a single trade. That way, your $1,000 would be used as efficiently as possible.
Disadvantages of Leverage Trading
Leverage trading gives traders more market coverage so they can invest more, and thereby, gain more profits. Please note that leverage should not be taken lightly as it can backfire.
Increased Trading Risk
Leverage trading can increase your profits and losses simultaneously.
According to the above example, as the value of your points increases with leverage, your capital will be subject to greater risks and losses. One loss of 10 points on a trade means $1 without leverage, but with leverage, a loss of 10 points on a trade means a loss of $50. Imagine this happening 10 times. Without the leverage, you can only lose $10, but with the leverage, you can lose $500. In this case, the trading account will empty in a short time.
Should a Trader Avoid Using Leverage?
Not really, you don't need to worry about the leverage once you understand how it works.
You can take advantage of the leverage by choosing smaller lot sizes for each trade and using proper risk management. Additionally, you need to decide the best leverage for your capital. Bear in mind that leverage is flexible and customizable, so you are free to manage it according to your trading needs.
