Surely you’ve heard of such a trading tool as a leverage. With its help, a trader earns a lot more income. What is leverage and what pitfalls does it hide?
What is leverage?
As you know, Forex trading requires investments. Transactions are measured in lots on Forex. A standard lot is equal to 100,000 units of the base currency. For example, in the USD/CHF base currency is the dollar, that is, the lot is 100,000 dollars. This is a very large sum, not everyone has it. Forex also allows you to trade with mini lots (10,000 units of base currency) or micro lots (1,000 units of base currency). That is to conclude a miserable deal, a trader needs to deposit at least $1,500-2,000, taking into account the fact that when the position is open, profit or loss are floating and a trader should have means enough for the position not to be closed. How many people will risk that amount of money? I think only rich men or nutballs.
Therefore, Forex brokers offer leverage. This is a special form of a loan which allows a trader to enter the market with small amounts. The broker gives money him and does not take percents for it. Herewith, a profit and a loss are increasing in proportion to the leverage and even minor fluctuations bring good income as well as losses.
So leverage is money that the broker lends traders to carry out transactions.
Features of leverage and margin trading
Forex hardly would be so popular without leverage. Thanks to it, participants of the market can trade even with tiny investments. The sum that the broker allocates his clients for trading is many times greater than the trader’s deposit.
For example, Jack has only 10 dollars, but he strives to trade. While registering with the broker, Jack chooses the leverage of 1:100. This means that the broker gives Jack money a hundred times greater than his deposit. So now Jack has $1,000 for trading and his 10 dollars become a margin.
This is the essence of margin trading, i.e. trading with leverage. Jack can not withdraw these $1,000, they provided to him conditionally. At the same time he is trading with large volumes and receives up to 100 times more profit.
Jack does not have to pay the broker anything for such a loan. When trading on Forex with leverage he affords to lose only his own deposit.
What types of leverage exist?
Leverage can be different: 1:1, 1:20, 1:100, 1:200, 1:500 or even 1:2000. 1:1 leverage means that a trader trades only at his own expense. A broker does not give him anything. Such trading is possible when the trader has a large capital, at the same time profits and risks are reduced.
Leverage depends on:
- broker’s policy;
- type of trading account;
- trading instrument;
- the amount in the account.
Ask yourself why the broker gives someone his money. Let me remind you that the broker provides the trader with money conventionally. He does not risk his own money, unlike the trader who runs the risk of his deposit. As soon as the position goes against the trader, the broker will “eat” trader’s money. First, he will send Margin Call, that is a notification that the money on the balance ends and it is necessary to make additional funds. If the trader fails to do that and the drawdown continues, then Stop Out will occur, that is the broker will automatically close the transaction. As a result, the trader will be left with nothing. And the greater the leverage, the greater the risks and the likelihood of the deposit loss.
For example, Jack and July have both 100 dollars on their deposits. Jack chooses for trading 1:100 leverage, and July – 1:10. Both Jack and July open similar orders for the same pair at the same time for a full amount of the deposit. That is, with the leverage Jack has $10,000 and July – $1,000. At some point, the position goes against the traders and the price decreases by 1%. For Jack, this percentage will be equal to $100, that is, to a full amount of his deposit. The broker will immediately send him a Margin Call or forcibly close the order. At that time, 1% for July will be equal only to $10, that is, $90 will leave on her deposit and she will continue trading. On the other hand, if the transaction is successful, Jack’s profit will be 10 times greater than July’s profit.
So, the greater the leverage, the greater the profits and RISKS!
What leverage to choose?
The bike can accelerate to 200 km/h. But this does not mean that you need to drive at such a speed. The faster you drive, the more likely an accident will occur. Same thing with leverage. It can play a cruel joke: the greater the amount you trade, the greater risk you run in case of drawdown.
How not to lose all the deposit?
To avoid a full drawdown you should reduce the risks. The following tips will help you with this:
- Use small leverage, maximum – 1:100. High leverage is a direct way to deposit loss.
- Place stop loss to control the risks. Determine the amount you are willing to lose in case of drawdown.
- Calculate your risk percentage. For example, you have deposited the account with 1,000 dollars and chosen the leverage of 1:100. A pip will cost $10. Let’s suppose you put stop loss in ten points from the order opening. If stop loss works, you will lose 100 dollars, i.e. 10% of the total account balance. In another case, you choose the leverage of 1:10 and each pip will cost one dollar. If stop loss works, you will lose only $10, i.e. 1% of the total balance.
- Do not open orders with the largest possible volume. This is not a casino, it all depends not only on luck.
- Develop your trading strategy and Forex will bring you a steady income.