All About Forex Trading Leverage
When searching for advantages of forex currency trading over other forms of financial instruments trading, one point you always get is the 'high leverage'. Forex trading involves very high leverage compared to stock, commodity and futures trades. This article is a detailed account of that.
What is Leverage?
Leverage is a very common trading practice of borrowing money from others to invest in a financial instrument. Generally, the money is borrowed from the broker you are trading with. The broker may charge interest on this leveraged money for overnight open positions. The amount of money you can borrow differs with brokers, product(s) you are trading and the type of your trading account.
Why Forex Traders need Leverage?
In currency trading we try to profit from very small changes in currency pairs known as pips. One pip is the smallest change in currency value and is the change in value of second or fourth decimal value of a pair. When trading with the dollar (eg: GBP/USD) a 100 pip move from 1.9000 to 1.9100 means one cent increase in exchange rate. So in that case for getting a $100 profit requires investing $10,000. And in reality you are trading for much less pip differences so you need very high trading investments for any reasonable profit. That is why there is high leverage in forex trading. A 1:100 leverage ratio means that you can trade $100,000 worth currency pairs by investing just $1000.
Margin Based Leverage Vs Real Leverage
Most brokers offer you leverage based on the margin you have. Margin is the minimum money you need to put up in your trading account for doing a transaction of a specific value. The general 1% (100:1) margin requirement of forex accounts means that you have to maintain at least $1000 in your account for trading standard $100,000 worth contracts. This margin-based leverage can be any where from 400:1 to 50:1. This differs from real leverage, and in fact it is actually defined as the maximum leverage a trader can enjoy in his trading account.
Real trading leverage is the ratio between the actual trading capital in your account and actual money you burrowed for all your current open positions. For example if you are trading $100,000 worth contract(s) and you have $20,000 in your trading account, then the leverage is 5:1. So this is very different from the margin-based calculation and is the factor to be considered when doing transactions. The optimum leverage for a trade depends on many factors like the liquidity of currency pair, trading style, brokerage features, trading experience and trader money management.
Advantages & Disadvantages of Forex Leverage
Many regard leverage as a 'double edged sward'. It can magnify both your profit and loss and the magnitude of both depends on how much leverage you taken. For example if two traders - trader A and B - trade with $20,000 accounts and opted for 50:1 and 5:1 leverages respectively; then they can trade $1000,000 and $100,000 worth contracts. If there is 100 pip profit, then trader A can benefit by $10,000 which is 50% increase to his investment and trader B can benefit only by $1000 a 5% increase to his investment. But in a reverse 100 pip loss scenario, trader A can loss $10,000 which is 50% loss to his investment and trader B can loss $1000 which is 5% loss of his investment. When trading on higher leverage there are also chances of margin calls. So a successful forex trader should know the this calculations and the way to utilizing it correctly.
This article is written for Orient Finance Brokers, a leading middle-east online forex trading broker. With an award-winning platform and tight currency spreads, OFB allows you to trade currency pairs with confidence. The online financial market trading blog by OFB is a very good source of trading information.