From what you’ve seen so far in the course, you must be wondering how on earth people manage to make a considerable income trading forex when the values for each pip are so small, especially when we use proper risk management.
People often think that you need vast sums of money and a huge trading capital to begin trading forex, but that is simply untrue. Welcome the wonderful world of leverage trading
Leverage is a tool that allows you to trade with amounts substantially higher than the amount that you have in your trading account by using your account balance as margin. Leverage is expressed as a ratio and is used to show the amount of money you have in your account and how much money you can actually trade.
For example, if you have $1,000 in your account and you have the possibility to leverage 30:1, then your maximum trading balance is $30,000.
Let’s use a real-world example from the property market to show the power of leverage and how it can drastically improve our bottom line.
A real-world example of leverage
Imagine you have £40,000, and you want to buy a property with your money. However, you want to buy something a little more expensive than your current budget allows.
You have your eyes on a £200,000 house and go to the bank to see if they can provide you with a mortgage.
The bank offers you the mortgage as long as you make a 20% down payment of the property value upfront.
This means that you are paying £40,000 in advance and the bank will loan you remaining £160,000.
In this example, you have bought the property using leverage of 5:1.
Fast forward by two years. Your property has increased in value to £300,000. This is an increase of 50%.
Now let’s take a look at the difference between leveraging and not leveraging in this scenario.
Imagine that instead, we bought a £40,000 studio apartment with our money and this also increases in value by 50%. How would our profits compare?
As you can see from the table above, using the same money we have managed to make an extra £80,000 profit by using the power of leverage.
This works in the same way in the forex market.
As with all things in life, there are some pro’s and con’s attached. Let’s take a look at some of the benefits and risks of using leverage in forex trading.
Benefits of leverage
- We can get a higher exposure to the market, which in turn allows us to profit at a much higher rate when our trade wins.
- Low margin requirements.
- Leverage is interest-free. Technically, leverage could be considered a short term, interest-free loan.
Risks of leverage
- Having a higher exposure to the market is a double-edged sword. If we have access to higher profits, it also means we have access to more significant losses.
- When trading at very high leverage, we can run into something called a margin call. This occurs when the value of your margin account falls below the broker’s required threshold. This gives the broker the right to immediately liquidate your portfolio, as well as any current trade trades and effectively wipe out your account.
A margin call can be easily avoided if we always trade sensibly, stick to our stop losses and employ an optimal risk management strategy.
Note: Leverage is not some magic formula that will lead you to make massive profits. It merely magnifies our trading position size and subsequently our gains and losses.