Leverage in forex trading: obvious advantages and hidden disadvantages
One of the major advantages of online trading is that Forex currency trading enables traders to start earning without investing large financial sums in the business.
Unlike the real trade, where a new businessman will need to buy or rent the appropriate area, to purchase goods, to bear the burden of overhead costs, in Forex trading the expenses are incomparably lower, because the transaction is carried out on the principle of margin trading, a constituent part of which is the presence of the leverage.
Leverage allows traders to enter into transactions for amounts many times greater than their own funds. Besides, the leverage allows Forex beginners to try themselves in real trading on the currency exchange market with a minimum amount of risky investments.
What is leverage?
- Leverage is a ratio of the amount of a contract traded by a trader to his own investments. It can be 1:1 (where a trader abandons the use of borrowed funds), 1:100, 200 or even 1:500 or 1:1000.
The most common variations of leverage in forex trading are: 1:50; 1:100; 1:200.
Forex beginners who opened a $1000 trading deposit without using leverage (1:1) should not expect to make much profit from online trading. The standard leverage of 1:100 allows the trader, in case of investing his own thousand, to operate the amount of $100,000 in Forex trading.
If everything is clear with the profit for the trader, then why does the broker have to help the average trader to earn money? The financial advantage of dealing is in providing a long term credit, which is a good promotional "gimmick" and helps to attract more clients to the service.
Recently, we often see advertisements where traders are provided 1:300 or 1:500 leverage and told what great profits can be achieved by using the leverage of the dealing centre with minimal investment of own funds. Only about the amount of losses, which increase in the same proportion as the profit, these advertising companies usually do not say, preferring not to spoil the working mood of Forex for novice traders with modest silence. Although, in case of trader's failure the broker, unlike the trader, does not lose his money. The deal is closed at the moment when the amount of loss is equal to the amount of the client's deposit. That is, the broker providing a sort of credit loan to the client does not risk anything under the pretext of promising earnings, monitoring financial situation with the deposit of the client. But the client, in the pursuit of profit with the use of leverage, risks only his own funds and the higher the risk is, the bigger the leverage is.
Advantages and disadvantages of leverage
Beginner traders should remember that Forex trading with leverage has both advantages and disadvantages.
As noted above, the first advantage of working with leverage is the ability to operate with large sums of money. A dealing centre gives a trader its own money as a loan or a trust. Having a small amount at his disposal, the player expects to get a good profit from trading on Forex, using the leveraged capital. This prospect of profit is what attracts most traders.
Another advantage of trading with leverage is the fact that traders cannot lose more than the amount they have invested. For example, a trader using 1:100 leverage and investing $1,000 will incur losses of this $1,000 if he loses, but not more.
But disadvantages of using leverage, which come from its advantages, are not widely publicized, though beginning traders must find out about this aspect of the matter before they start trading. Trading on Forex market and using large leverage in case of insignificant market movements against a trader's position, the trader may find himself in a situation of margin call and lose most of his deposit. The use of leverage in Forex trading is akin to drinking alcoholic beverages. A small dose is good for the body, a large dose is a deadly poison.
Basic rules of trader's trading system
To avoid stressful situations as much as possible, it is necessary to include several important rules into working Forex strategies, and strictly follow them:
1. Do not use all of your funds in operations, but only a part of them. Be aware of how to effectively manage your capital (money management).
2. Do not forget to place protective orders (Stop Loss).
3) Do not run after an unbelievable chance of instant wealth by choosing the best Forex trade leverage (usually not more than 1:100). It is better to trade smaller amounts than to watch others trade.
Leverage is a complex but nevertheless very convenient tool for trading in the financial markets. It can help a trader to get rich as well as quickly ruin an unlucky player. That's why its application requires from a trader concentration and accuracy, necessary knowledge and skills that fit in the notion of trading system.