Leverage is the ability to make large trades in the market with only a small amount of actual capital in your account. Forex brokers offer leverage as a way to make the market accessible to the average investor. Most traders do not have $10,000 to get started with forex trading. If a forex brokerage provided a trader with the leverage of $200 to every $1 deposited (200:1 leverage), it would only take a deposit of $50 to open and control a $10,000 trade.
How Leverage Can Hurt You
Leverage can be a sharp double-edged sword. It can work for you, or against you. If you make a trade with a mini trading lot of $10,000, each pip would be worth around $1. If you gain 5 pips, everything is great, you used $50 and made a 10% return. If you lose 5 pips, you have a 10% loss just as fast.
While it is really nice to think about the money you can make, the money that can be lost is rarely discussed. Leverage can be very dangerous if used improperly. Brokers can offer heavy leverage, but that does not mean that you are forced to use it all the time. Many traders often use less than 5 times leverage. While the possible gains are smaller, so are the possible drawdowns.
Using Extreme Leverage
While looking for a broker, you will discover that there are brokers out there that offer extreme leverage. Some brokers will even offer you 400:1 leverage. This would allow you to open an account with $300, and use that same amount to control up to $120,000 worth of trades. The average pip size with a trade of $120,000 is $12.00. If your trade lost 25 pips, your entire account would be wiped out. Considering that most currency pairs can move 25 pips in less than 10 seconds, that sounds pretty dangerous, doesn't it?
Using Leverage as a Tool
The dangers of using too much leverage are rarely talked about but are pretty obvious if you think about it. This doesn't mean that you have to use the full amount of leverage just because it's there. In fact, there are ways to use leverage in useful ways that will give you an advantage.
A good time to use leverage is when adding to a winning trade. If you have a trade that has progressed favorably and you want to add to it, this is a good use of leverage. This is called leveraging your profits.
Overall the best use of leverage is when position trading. It's tempting to use extreme leverage to make a fast profit on single trades, but the risks are just not worth it. This is especially true given that the future is uncertain.