Trading forex can be very enticing to those individuals looking to start trading forex regularly. One of the most attractive aspects of trading forex is the amount of leverage that you can utilize. When comparing forex to other financial instruments the leverage that is available is generally higher than most instruments. It is very important to learn about leverage and margin as while the reward can be very enticing the risks can be substantial.
What is Leverage
The term leverage describes your ability to borrow a specific amount of money to invest in a financial instrument. Leverage describes how much money you can borrow from your broker, to purchase a currency pair. Leverage is the amount of capital that you can borrow divided by the amount of capital you need to post for collateral.
Both experienced as well as inexperienced forex traders need to have a firm handle on how to use leverage prior to trading within their forex brokerage account. Many small an inexperienced forex traders don’t use leverage properly.
Small traders tend to expose their account to high levels of effective leverage. When this happens the inexperienced forex trader exposes themselves to significant losses in their forex accounts.
Typically, when inexperienced forex traders leverage large sums of money if they are unsuccessful this can cause an endless cycle which will invariably damage their enthusiasm which attracted them to trading in the first place.
An example of the margin calculation, shows how you can figure out your leverage. If you decide that you wanted to purchase $100,000 of USD/JPY and your forex broker required to deposit one percent of the total transaction value as their margin amount you would need to post $1,000 to place the trade. In this instance, the amount of leverage is 100:1 or ($100,000/$1,000).
When leveraging and trading in forex the movements of the currency are in pips which are the smallest change in currency prices. The movements in pips are fractions of a cent. This explains why currency transactions are carried out in large amounts which allow these small price movements to be translated typically into solid profits when magnified with the use of leverage.
When a forex trader is dealing with a large amount such as one hundred thousand dollars, the smallest changes in the price of currency can either result in either huge profits or huge loses.
You are given the freedom along with the flexibility to select their leverage amount which is based on their trading style and money management preferences. Some brokers provide leverage as high as 500:1, which would mean that you would only need to post $200 to control $100,000.
While you might be able to generate significant gains, your risk of ruin is also high. For example, if you used 500:1 margin and posted $200 dollars for a $100,000 USD/JPY trade, and lost 20 pips when the USD/JPY was 110, would be $181, which would nearly wipe out all of your capital.
By having the ability to utilize leverage you can generate significant gains, but you need to understand the risks you will take to avoid the risk of ruin.
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