Leverage is used by investors and traders to significantly increase the returns on their trades.
It works as a type of loan that is provided by a broker that is handling the trader forex account.
Using leverage allows a trader to essentially control a larger account than what they would normally be able to.
A high amount of leverage can be obtainable in the forex markets compared to other markets
In the forex market leverage can be as high as as high as 100:1.
How leverage works
So how exactly is leverage applied when trading?
With $1000 to trade you could be able to trade a $100,000 position.
The broker will set aside $1,000 from your account and essentially borrow to you $100,000.
This would mean that you’re now controlling $100,000 with just $1,000.
The leverage you are now using as a ratio is 100:1.
If you were to make $1,000 profit from the $100,000 investment then this would actually be a 100% profit on your $1000 investment.
This would be different if you funded the entire $100,000 capital yourself in which $1000 profit would be a return of just 1%.
Of course this also works the other way if you were to loose $1000.
Pro’s and cons of leverage
So using leverage may seem like a win/win scenario but as we briefly mentioned before there are pro’s and cons to using it when trading.
It could take years for a trader to earn any noticeable profit on a small sized account such as $1000.
Using leverage can greatly increase your returns, this allows traders with smaller funds to be able to trade much larger positions.
Although it can greatly increase your returns it also greatly increases your risk of high losses.
You have a $1000 funded account using 100:1 leverage.
If one trade were to move in the opposite direction of what you believed would happen then the leverage will greatly amplify the potential losses.
Any losses are first taken from the traders investment meaning that the chances of wiping out the account are much greater.
So should you use leverage?
There inst really a right or wrong answer to this.
If trading with leverage then a trader should implement a more stricter trading style to reduce the risks.
This could include using stop and limit orders designed to control potential losses.
Generally the risk should never be more than 3% of trading capital, if the risk is higher then the amount of leverage should then be reduced.
Traders can also reduce risk by adjusting the level of margin that they use.
By reducing the lot size this means that each pip would be worth less, reducing risk but also potential profit.
If you do choose to use leverage when trading then remember to use a more stricter risk management to reduce your risks.