Experienced traders know that trading currency usually involves a good amount of risk. They also know how and when to use leverage, to a reasonable degree, to turn their trades in their favor. Now leverage is a powerful concept, and it can be a dangerous tool too, if not used judiciously. Novice traders often end up making the mistake of leveraging trades with high risk and low returns. Why? They simply do not understand the concept of leverage, or how powerful the impact of leverage can be on their accounts. While they see the profits they can reap, they often ignore the big risks that leverage brings.
Wise use of leverage can result in profits, but that is possible only when the trader knows both the benefits and the pitfalls of it. Here are a few ways in which you can tap the power of leverage in forex trading.
Understand what leverage is
Understanding of leverage is key to tapping its power in forex trading. Leverage is a by-product of margin, and is used to magnify the returns by many times. If not used prudently, leverage can also result in huge losses for the trader. So, knowing how to control leverage is essential before you can use it.
The high risk factor associated with leverage, and the fact that most traders end up using it the wrong way, has resulted in bad propaganda of leverage. This is also perhaps the reason why many forex brokers need the trader to have a certain level of expertise or experience before they are allowed margin trading.
Cap your losses
A wise man once said, temptation leans on the doorbell, while opportunity knocks only once. It is easy to get tempted to make huge profits without having to spend a lot from your own pocket. When you are tempted to use leverage in forex trading, it is important to remember that the chances of you making the profit with it are equal to the chances of you losing a huge amount. Big losses in forex trading have direct consequences and can even mean the end of trading for a few novices. So the first thing to keep in mind when using leverage in forex trading is to limit your risk, and with it your losses too. Capping the losses makes it easier to manage them.
Always remember - too much leverage is bad
Today, leverage can be as high as 200:1, which means traders can magnify their investment by 200 times for every dollar in their account. The maximum leverage you are offered usually depends on your broker, depending on your trades and their terms. So it can be 50:1, 100:1, or even 400:1, if the broker allows it. But using maximum leverage just because you are being offered it is a bad idea. Before jumping into the trade, it is essential that you analyze your position and see if you are comfortable using the leverage in it.
When in doubt, talk to the experts to prevent a bad decision from wiping out your entire margin. Beginner traders should always use low levels of leverage and must always play cautiously. Safety should always come first, and should not be overridden by the possibility of making big money easily.
Calculate Effective leverage
It is true that the leverage you get is determined by the broker, for leverage is nothing but funds you borrow to make trades. However, the leverage you use should never exceed the effective leverage, which the position size/ equity in your account. So even if the leverage offered by the broker is higher, which is seldom the case, avoid using it if it exceeds your effective leverage.
Know how much leverage to use
As stated before, it is not necessary to use the entire leverage you have in your account. Leverage must be used keeping in mind the impact it will have on your account. The higher the leverage, the bigger the upward or downward swing will be in your account, and vice versa. Ideally, the leverage you use, regardless of what is being offered in your account, should not exceed 10 times the effective leverage.