Leverage on Forex trading remains one of the most misunderstood concepts in trading. Read this article, to learn, what it is, what the biggest misconceptions are concerning leverage, and what benefits and risks are involved.
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An Introduction to What Leverage Is in Forex Trading
Leverage refers to borrowing funds from your broker and forms the backbone of Forex trading. Without leverage, Forex trading, especially retail trading, would be impossible. Forex leverage of 1:500 is the industry standard. This means traders can control $500 for each $1 in their portfolio.
Brokers charge daily financing on borrowed capital known as swap rates, which triple each Wednesday if traders have kept weekend positions. Swap rates are the most ignored trading fees among traders who keep leveraged overnight positions.
While brokers allow traders to borrow capital, they never risk a loss, as they issue a margin call once the portfolio drops to a specific capital ratio, which is expressed as a margin level in the trading platform. The broker will start liquidating positions automatically if the trader fails to meet a margin call.
Forex trading works with leverage, which offers many benefits, but most traders feel the negative impact of using leverage unwisely and do not understand its relationship to risk management. They associate higher leverage with higher risk, which is a grave misconception. Understanding leverage will allow traders to manage risk and maximize the results of their strategies.
How Much Leverage is Right for Your Trades?
The ideal leverage ratio on Forex trading that a trader should use depends on their risk management strategy. No magic ratio exists or can shield traders from magnified losses. Tier-1 regulators, outside New Zealand, have slashed maximum Forex leverage to 1:30. However, this only delays the potential for total loss by a few trades, as risk management defines risk, not leverage.
Leverage and lot size determine how many pips a position can move against a trader before risk management should exit the trade.
Tips on Leverage Trading in Forex
My tips below can help Forex traders use leverage properly and minimize the downside.
Tips on using leverage in Forex:
- Understand the relationship between risk management and leverage
- Use appropriate lot sizes
- Have sufficient capital
- Avoid overtrading
- Master stop loss and take profit placement
High Forex Leverage – Pros and Cons
The best high-leverage forex brokers will provide a wealth of risk management tools to enable traders to mitigate their exposure responsibly. High leverage can optimize profit potential but also maximize potential losses. Therefore, traders should consider the pros and cons of Forex leverage before using it.
The Pros of Forex Leverage
- Lower capital requirements
- Greater flexibility
- Increased profit potential
- More trading opportunities
The Cons of Forex Leverage
- Lack of risk management
- Overtrading
- Increased loss potential
- Insufficient capital
Bottom Line
Leverage is essential to enable Forex trading for retail traders. The maximum leverage on Forex trading depends on the Forex broker, but the best Forex brokers offering high leverage provide 1:500.
