An Explanation of Leverage
Understanding the Use of Leverage
Leverage is the ability to use something small to control something big. Specific to forex trading, it means you can have a small amount of capital in your account controlling a larger amount in the market.
Stock traders will call this trading on margin. In forex trading, there is no interest charged on the margin used, and it doesn't matter what kind of trader you are or what kind of credit you have. If you have an account and the broker offers margin, you can trade on it.
The obvious advantage of using leverage is that you can make a considerable amount of money with only a limited amount of capital. The problem is that you can also lose a considerable amount of money trading with leverage. It all depends on how wisely you use it and how conservative your risk management is.
You Have More Control Than You Think
Leverage makes a rather boring market incredibly exciting. Unfortunately, when your money is on the line exciting is not always good, but that is what leverage has brought to FX.
Without leverage, traders would be surprised to see a 10% move in their account in one year. However, a trader using too much leverage can easily see 10% move in their accounts and one day. While typical amounts of leverage tend to be too high, I trade with five times leverage; it is important for you to know that much of the volatility you experience when trading is due more to the leverage on your trade than the move in the underlying asset.
Leverage is usually given in a fixed amount that can vary with different brokers. Each broker gives out leverage based on their rules and regulations. The amounts are typically 50:1, 100:1, 200:1 and 400:1.
Fifty to one leverage means that for every $1 you have in your account you can place a trade worth $50. As an example, if you deposited $500, you would be able to trade amounts up to $25,000 on the market using 50:1 leverage. It's not that you should be trading the full $25,000, but you would have the ability to trade up to that amount.
One hundred to one leverage means that for every $1 you have in your account, you can place a trade worth $100. This is a typical amount of leverage offered on a standard lot account. The typical $2000 minimum deposit for a standard account would give you the ability to control $200,000.
Two hundred to one leverage means that for every $1 you have in your account, you can place a trade worth $200. This is a typical amount of leverage offered on a mini lot account. The typical minimum deposit on such an account is around $300. With $300 you would be able to open up trades up to the amount of $60,000.
Four hundred to one leverage means that for every $1 you have in your account, you can place a trade worth $400. Some brokers offer 400:1 on mini lot accounts. I would personally be wary of any broker that offers this type of leverage for a small account. Anyone making a $300 deposit into a forex account and trying to trade with 400:1 leverage could be totally wiped out in a matter of minutes. It's not as if the brokers force the trader only to deposit $300, but if they make it possible, I suspect that there are also other ways that they will not act in your best interest.
Professional Traders and Leverage
For the most part, professional traders trade with very low leverage. Keeping your leverage lower protects your capital when you make trading mistakes and keeps your returns more consistent. Many professionals will use leverage amounts like 10:1 or 20:1. It's possible to trade with that type of leverage regardless of what the broker offers you. You have to deposit more money and make fewer trades.
No matter what your style, always remember, just because the leverage is there does not mean you have to use it. In general, the less leverage you use, the better. It takes the experience to know really when to use leverage and when not to. Staying cautious will keep you in the game for the long run.