What Is Leverage in Forex Trading and Why Is It Important?

Leverage in forex trading is an important but very often misunderstood concept. A widespread and very naïve definition of leverage is that it’s a tool that will help you make money quickly and easily. While one of the biggest advantages of trading forex with CFDs is the use of leverage, very often traders ignore or forget the risks involved. Leverage is a powerful tool that can help small traders, like you and me, compete with the bigger players and potentially earn more by depositing only a small amount of funds. However, leverage can also be very damaging to a trader who doesn’t understand leverage. While leverage may allow you to open a larger position worth much more than your initial deposit, it can also lead to losses. So being aware of the risks is important in making responsible decisions that will not decimate your account.

Understanding Leverage in Forex Trading

Financial leverage in the forex market creates many opportunities for everyday traders who don’t have a massive amount of capital. The pasar forex was initially the playground of big financial institutions and banks, but with leverage and buying on margin, traders can increase their trading power and take advantage of currency movements.

Without the use of leverage, retail traders would not be attracted to forex. In other words, leverage is what makes forex more accessible to people like us, who want to participate in the most liquid market in the world, but don’t have the fortune to do so.

A useful way of understanding leverage is seeing it as credit or loan, which will allow you to trade with money borrowed from your broker. It is also defined as the use of foreign capital per unit of capital invested.

Leverage is what makes it possible for forex brokers to operate. Brokers have accounts in banks which serve them as liquidity providers. The banks act as lenders of first resort for the broker’s margin transactions, allowing the forex broker to trade with larger amounts of capital, which in turn allows the broker’s customers to trade with larger amounts of capital too. The deposited capital in the bank secures limited risk, in the same way that your deposit with the broker does.

Trading with margin

When you trade forex with CFDs, you aren’t buying the physical currency and depositing it into your account, but you are speculating on the currency’s exchange rate. With a Contract for Difference (CFD), you enter into an agreement with your CFD broker that they will either pay you, or you will pay them, depending if the exchange rate moves in your favour or not.

If you buy a GBP/USD standard lot, you don’t have to put down the full value of the trade (100,000 GBP). However, to increase the trade size to the institutional level, you must make a deposit known as a “margin.” The minimum deposit capital is different for each broker and can be anything from $50 to $100,000. IronFX allows traders to start with as little as $50 and $100.

Since you are borrowing a sum of money from your broker, margin trading can be described as trading with borrowed capital. You can say that your broker gives you a loan based on your deposited amount. This is what brings us to leverage, as margin trading is what enables the use of leverage.

Your initial deposit is basically a guarantee for the leveraged amount of, let’s say, £100,000 we mentioned above. You deposit a small amount as collateral which will also cover potential losses, so the broker can give you the rest of the amount to trade with. Your deposit is not then used as a payment or to buy currency but is a guarantee to your broker.

When you execute a trade, a percentage of the deposit in the margin account will be suspended and kept as the margin requirement for the trade. How much margin is required for each trade will depend on the currency pair, the exchange rate and the number of lots you will be trading. The lot size always involves the base currency. The initial margin requirement may not be used in trading until you close the trade. If you open more positions at the same time, then you will have to keep more margin until it becomes a significant percentage of your account.

Dangers of high leverage

Leverage is one of the key reasons many beginner traders, and sometimes older traders, get disappointed and give up after losing all their capital. By using small accounts with extremely high leverage, they end up being eaten by the bigger fish such as the more professional traders who tend to use less leverage.

Many traders believe that after experiencing losses they can make their money back and offset their losses by using leverage. This, however, tends to result in their account suffering substantial losses than making any gains. When their account is drained and ends up with less money than the minimum margin account level, their broker is forced to close the position leaving them with whatever money is left in the account.

The pros of using leverage in forex trading

1. Magnified profits with small deposits: Leverage gives the opportunity to traders to make bigger profits with a relatively small amount of capital. This has made forex trading and CFD trading popular among retail traders.
2. Trading larger positions: Retail traders such as yourself, can access the forex market, which is the biggest financial market in the world, and compete with bigger players, trading large positions thanks to leverage.
3. Portfolio diversification: With leverage, traders can diversify their forex portfolio and trade different currency pairs at the same time, avoiding putting their eggs in one basket and spreading risk across various currency pairs.

The cons of leverage in Forex trading

1. Increased losses and margin calls: While leverage can increase profits, it can equally increase losses as the market can move unpredictably, even decimating your account. A margin call happens when the percentage of your equity in a margin account falls below the required amount. This will require you to deposit additional money into the account.
2. Emotional effect: Leveraged trading can be quite stressful and draining emotionally, so beginner traders may find it difficult to handle the stress that comes with trading with lots of money.
3. Overtrading or trading on impulse: High leverage can lead many of us to overtrade or take too many risks, which could lead to more enormous losses.

Trading with leverage can be risky but also rewarding. So, make sure you understand the risks involved and pick a reliable broker you can depend on when things get hard. IronFX is a trusted and reliable name in the industry and a great broker who can offer assistance and support when needed. With 24-hour customer support, 5 days a week, as well as your own dedicated account manager, you can trade with extra help and find out the answers to all your questions. With extensive education, the latest platforms to trade on your desktop or on mobile, as well as some of the lowest spreads in the market, IronFX won’t disappoint. Register now with us and leverage your trading with a powerful broker.

Disclaimer:

This information is not considered investment advice or an investment recommendation, but instead a marketing communication. IronFX is not responsible for any data or information provided by third parties referenced or hyperlinked, in this communication.