Leverage is presented as a great financial tool in forex, which can help you earn greater profits. Without a doubt, leverage is an asset that can be used for greater gains but when it comes to beginners, it is mostly a trap. It is very important that you clearly understand the concept of leverage as it is mostly misunderstood.
New traders generally make the mistake of considering leverage as credit. Leverage is not credit. It is simply the ability offered by the broker to you to trade more. You only have leverage until your trade is making a profit. As
soon as you start sinking in the red, the leverage cover gets blown very fast.
You must understand that leverage doesn’t provide any cushion to you. It is just not a loan with a term attached to it. It is a tool that can help you sping up higher. The higher you jump, the greater is the risk of crashing heavily.
Let us understand the good and bad of leverage.
Suppose you are a dreamy-eyed trader looking for a business opportunity with just a $100 bill in your pocket. You have a trading market in front of you. You are convinced that if you get a chance to trade in this market, you
will be able to make it big. You have a feel of the pulse of the market, and you understand it better. But, a $100 bill can’t get you an entry into the market. Even if you buy something, it wouldn’t have the potential to earn
you anything.
You see a big businessman looking at you. That businessman has a better plan. He has the money, but he doesn’t want to risk it. He tells you that he has a say in the market and he can allow you to trade anything 100 times
the money in your pocket on the condition that before the day’s closing, you’ll close the trade.
The unconditional clause is closing the trade before the trading session closes. It would happen irrespective of the fact that you are making a profit or loss in the market.
The businessman takes a cut on all the transactions irrespective of the fact that you gain or you lose. The ultimate power to square off the transaction also lies with the businessman whenever the deal reaches a critical point at which the total loss is near your total investment.
Who do you think stands to lose in this transaction?
The businessman has nothing to lose. Not even a single penny, although it looks like that the greater part of the investment is on the side of the businessman.
The businessman has a cut in every trade irrespective of the fact that you make a profit or loss in it The businessman wields the final authority in squaring off the transactions in which the total loss is reaching the critical point at which the total loss is equal to your investment. This means that the loss, if any, is going to be on your part.
You will have to square off the transactions before the closing of the trading session. The businessman might not have to invest a single penny in reality as his credibility alone can help you do the transaction for that short term, and he’d be making a profit at your risk.
This is the game of Leverage in forex.
The forex brokers offer the highest leverage in the market to the traders. In forex trading, you can expect to get 1:500 leverage too. This means that the broker can allow you to buy trades over 500 times the value of your investment.
This means if I want to get into a USD/EUR trade using $200. The broker may allow me to buy approximately 5 mini lots of 50,000 units. This can be an opportunity or a fiasco, depending on how you deal with it.
A big problem with leverage money is that people don’t understand the gravity of the situation in reality.
The leverage money is not a term credit. It is a tool good till the end of the day or until your trade is lingering above the danger mark.
If you get into a trade and your trade is not in the positive, but it has the potential to get profitable if you can hold it for a little while longer, you won’t be able to do that as you are required to square off the trades on the
same day. Carrying over forex trade overnight has great risks as the other markets may bring steep price movements.
If your trade starts moving rapidly towards the negative mark or your margin money is not sufficient to cover the cost of the spread, the broker would raise a margin call and if that is not answered by you, the trade will be squared off immediately as the broker wouldn’t take the risk of his money. Therefore, there are several disadvantages of using high leverage in forex.
Leverage is not an entirely bad thing.
If you use leverage judiciously and cautiously, it can help you in getting more profit. It enables you to buy more assets if you keep your bases covered. However, you must also never forget that buying more assets also
means that you will be putting more money at risk.
When you use leverage, you must keep your stop losses tight and do not buy very high volumes that cannot cover the cost of your spread comfortably until the entire depth of your stop loss. You must also be prepared to bear the losses to that amount comfortably, and that’s why it is advised that your overall stop loss shouldn’t be greater than 1%-2% of your
total account value.
When you use leverage, you must keep your stop losses tight and do not buy very high volumes that cannot cover the cost of your spread comfortably until the entire depth of your stop loss. You must also be prepared to bear the losses to that amount comfortably, and that’s why it is advised that your overall stop loss shouldn’t be greater than 1%-2% of your total account value.
Most traders know this, but the fear and greed are two very strong emotions that can take over the trading decisions many times.
The government understands this, and that’s why to prevent the interests of the traders in the US, the government has put a maximum capping of 1:50 leverage on the brokers. This means that the brokers cannot give leverage higher than 50 times the total account value of the trader.
In the end, it is important to reiterate that leverage is just a tool. It shouldn’t be considered an asset. It should also be never taken as a term credit. It is just an advantage offered to the trader, which only holds good till the end of the current trading session or the triggering of the margin call, whichever occurs first. However, if you use it properly, you can gain more profit while keeping your account safe from a complete wipeout.
