Leverage in Forex Trading
Leveraged trading in foreign exchange markets is usually as high as 100:1. It means that for every $1000 in the account, the value that the trader can trade is up to $100,000. A lot of traders believe that these high leverage offers by the forex market makers is due to the fact that leverage is a risk. They know that there will be a very manageable risk if the account is properly managed or else, they will not offer leverage. In addition, the ability to enter and exit a trade in a preferred level is easier since the spot cash forex markets are huge, and liquid compared to other less liquid markets.
The currency movement in trading is monitored in pips. Pip is the smallest change in the price of the currency pair. These movements are infractions of a cent. For example, a move of 100 pips which is from 1.9400 to 1.9500 in a currency pair like GBP/USD is equal to 1 cent move of the exchange rate.
Currency transactions must also be done in a considerable amount. Through leverage trading, it allows minute price movements to become larger profits when magnified. Dealing with an amount like $100,000 can lead to significant profits or losses in just small changes in the currency price.
Excessive Real Leverage: Risk in Forex Trading
Real leverage has the potential to magnify profits and losses in the same magnitude. Therefore, it is called a double-edged sword. The greater the leverage amount on the capital, the higher the risk it will have. This risk is not necessarily related to margin-based leverage though it can affect if the trader is not careful.
For an example:
Both Trader A and Trader B have a trading capital of US$10,000. The trade with a broker requires 1% margin deposit. They both agreed that USD/JPY will gain and fall in value after doing some analysis and research. And so, both short USD/JPY at 120.
Trader A applies 50 times real leverage on this trade, shorting US$500,000 worth of USD/JPY (50 x $10,000). This is based on the trading capital of US$10,000. Since USD/JPY is at 120, 1 pip of USD/JPY for 1 standard lot is approximately worth US$8.30. So, 1 pip of 5 standard lots of USD/JPY is worth approximately $41.50. If USD/JPY goes up to 121, Trader A will lose 100 pips on this trade. This is equal to a loss of $4,150. This single loss represents 41.5% of the total trading capital.
Trader B is more cautious and decides to apply 5 times real leverage on this trade, shorting US$50,000 worth of USD/JPY (5 x $10,000). This is based on the trading capital of US$10,000. The $50,000 worth of USD/JPY is one-half of one standard lot. If USD/JPY goes up to 121, Trader A will lose 100 pips on this trade. This is equal to a loss of $415. This single loss represents 41.5% of the total trading capital.
Proper management of leverage trading is the key so there is no need to be afraid of it. It is profitable once there is a hands-on approach to trades. It must be handled carefully like any other sharp instrument.