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Understanding Leverage in Forex: Popular Leverage in Trading Tips You Need to Know

How Leverage Works in the Forex Market
What is Leverage in Forex Trading? Foreign exchange, usually shortened as forex, is the process of converting one national currency into another; probably for tourism, e-commerce, etc. But, the business of exchanging one currency into another in order to make profits from the unstable exchange rates is referred to as forex trading. The virtual marketplace where currencies are traded by global participants is known as the foreign exchange market. It is by far the biggest market in our world today and remains open 24/5.

Only huge volume traders such as the large international banks, hedge funds, big investment firms, etc have direct access to the forex market. But, the retail forex traders, who trade smaller volumes, have access to the forex markets via online forex brokers. These are financial service providers who give individual traders access to software platforms where they can trade forex and other financial instruments. Services offered differ from one forex broker to another and most times, finding the right broker becomes a problem.
Some brokers are regulated by constituted financial authorities while others are not. For example, in South Africa, brokers are licensed and regulated by the Financial Sector Conduct Authority (FSCA), in UK; they are regulated by the Financial Conduct Authority (FCA), in Belarus, and the National Bank of the Republic of Belarus (NBRB) handles the regulation of brokers. Regulated brokers has proper management teams, play by the rules, offer better facilities and create fair trading environments for traders to succeed. 

Content:
  1. What is leverage?
  2. Leverage in forex trading
  3. Leverage and Margin
  4. Example to illustrate how leverage works
  5. Advantages of leveraged trading
  6. Disadvantages of leverage trading
  7. Leverage Trading with InvestBy
  8. Summary
  9. FAQ: Learn how to trade Forex in South Africa

What is leverage?

Leverage is like trading on a credit facility provided by the broker; it is like a loan given to a trader to open trade positions that are much higher than his initial investment. Leveraged trading is available in several financial markets such as stock markets, Options and futures market, etc. In the stock market, leverage is done by opening a margin account with your stockbroker, depositing the required amount, borrowing funds and trading with the increased capital. In the futures market, you are required to make a deposit but there are no interest fees.

Leverage in forex trading

Leverage is a powerful tool used by traders to multiply their market exposure thereby creating opportunities for higher profits or losses. Leverage is expressed as a ratio of the trader’s capital to the broker’s credit. For example, a leverage of 1:50 means that for every deposit made by the trader, the broker offers him 50 times more. So, with a deposit of $100, the trader will be able to trade with a total trading capital of $5,000.

Every forex broker defines its own maximum leverage for each tradable asset. Some offer very high leverage like 1:3000, 1:2000 while others over low forex leverage like 1:20, 1:10, etc. In Europe, the The European Securities and Markets Authority (ESMA) restricts forex leverage to a maximum of 1:30 on major currency pairs and 1:20 on minors and exotics. Similarly, in USA, the Commodity Futures Trading Commission (CFTC) limits forex leverage available to retail traders to 1:50 on major currency pairs and 20:1 for other pairs. 

Leverage and Margin

Margin is another forex trading concept that is related to leverage. Margin is the money required by the broker in order to allow a trader to open higher trade positions. It is part of the trader’s capital set aside in order to cover losses in case the trade goes against your position. It is expressed as a percentage while Leverage is a ratio. You can easily calculate leverage ratio from the margin percentage and vice versa.

For a leverage of 1:100, margin percentage = (1/100) X 100 = 1%.

Similarly, leverage of 1:200 = 0.5% margin and so on. 

Example to illustrate how leverage works

If a trader decides to go long on 1 lot of EUR at 1.16362 on a leverage of 1:400, what is the margin?

Notional or total value:

                  Trade size X entry price = 100,000 X 1.16362 = 116,362

Required Margin = (1/400) X 116,362 = $290.91

Margin percentage = (1/400) X 100 = 0.25%

In other words, to open a trade of 1 lot of EURUSD, instead of paying the full value of $116,362; the trader only deposits $290.91 which satisfies the broker’s margin requirement of 0.25%. This amount is locked in the trader’s account by the broker and the trade is opened. Since the trader opened a long position, he forecasted that the currency prices will go up and if it does, his floating balance begins to increase. But, if the prices begin to decline, his floating assets begin to reduce and if it continues and reaches a certain threshold, a ‘margin call’ is issued. At this point, the trader is notified to make more deposits or close the position. Assuming he remains optimistic or ignores the call and prices continue to decline, his position is liquidated.

Advantages of leveraged trading

  • Reduced trading capital
Courtesy of leverage, anyone can delve into forex trading with a paltry sum of money as capital. Some brokers have no minimum deposits; any amount will suffice to commence forex trading. For example, if the USDZAR is quoted as follows: bid price 14.5570 and ask price is 14. 5655 and the broker offers a leverage of 1:500.

To open a buy position for 1 micro lot = 1,000 X 14.5655 = 14,565.50

Margin required = 1/500 X 14,565.50 = 29.13 ZAR

So, only a small sum of money, less than 30 ZAR is required to commence forex trading with this broker. 
  • Profit potentials
When leverage boosts the trading capital, it creates an opportunity for the trader to make more profits. Trading with a huge capital increases the value of a pip which translates to higher profits if the market goes in the trader’s direction. Leverage has remained one of the greatest attractions to forex trading because many traders believe they can easily make profits, but sadly, they lose their invested capital when the trade goes in the opposite direction.
  • Forex leverage is free
In the stock market, you will need to open a margin account with your stockbroker and fund it with a specified amount before you can trade on leverage. The borrowed funds will be returned with an interest irrespective of the results of your trade. But leverage in forex is completely free; there are no interests. 

Disadvantages of leverage trading

  • Leverage amplifies losses
Just as it increases potential profits, leverage in forex equally multiplies a trader’s losses if the market reverses against his position. This is exactly why every forex and CFD broker has a risk disclosure statement that warns retail investor accounts of losing money rapidly especially when trading leveraged products. The markets are unpredictable and can be volatile; one reversal can wipe out a trader’s funds and high leverage translates to high risk.
  • Margin call risk
This is a notification from the broker to the trader to either add more funds or close his losing positions. Depending on the broker, it might be in form of sms, email, app notifications, etc.

Leverage Trading with InvestBy

InvestBy is a forex and CFD broker that gives its clients access to speculate on more than 350 assets on its trading platforms. The broker is located in Belarus but accepts clients from different countries. It has implemented cutting edge technology which ensures low spreads and very fast executions. InvestBy offers its clients forex leverage up to 1:100.

To start trading forex and CFDs with InvestBy, do the following:
  1. Signup for a new trading account by clicking on ‘open account’ and filling the ensuing form.
  2. Submit your verification documents; an ID card and utility bill.
  3. Transfer your trading capital to the new account using the most convenient option.
  4. When your account is approved, open a forex or CFD trade position on the WebTrader or MT4 trading platform.
  5. You may close the position anytime you want.
Note that trading CFDs come with the high risk of losing your invested capital. Previous success is no indication of future good results; there are no guarantees.

Summary

Individual forex traders can trade forex through online brokers. Leverage is a powerful tool used in several markets including forex, stocks, futures, etc. It enables traders to enjoy greater market exposure and open positions that are larger than their invested capital. You can calculate leverage ratio if you know the margin percentage. Trading leveraged products come with a high risk because it magnifies both potential profits and losses in the same proportion.

Investby is a modern forex and CFD broker that is determined to provide a conducive trading environment for it clients. The broker has sophisticated platforms which are optimized for expert traders yet simple enough for newbies. Successful traders are knowledgeable; they use various trading strategies and manage risks effectively. This is why InvestBy provides an education centre, multiple risk management tools and allows all trading strategies including trading robots. Its platforms are equipped with tools for technical analysis and order management. If you are in doubt, you are welcome to try out its demo accounts with no risks involved.

FAQ: How Does Leverage Work in Forex Trading?

What does a leverage of 1:200 mean in forex?

It simply means that the broker will multiply the trader’s funds by 200. It is like giving him more money to open greater positions with the opportunity to rake in higher profits. So, if you make a deposit of $300, your broker will allow you to open trade positions that are worth $60,000. Traders can have more opportunities to magnify their profits due to leverage, but it may cause greater losses in bad trade.

Is leverage good or bad?

Leverage is supposed to be good because it can help a trader to grow his capital and make more profits but it can be bad when it multiplies losses on a losing trade. That is why Leverage is referred to as ‘a double edged sword’. So, it is not outrightly good and not completely bad. It is left for traders to find a balance by honing their trading strategies and risk management principles.

Can you trade forex without leverage?

Of course! You are not under obligation to utilize the maximum leverage provided by your broker. When creating your trading account, just specify a leverage of 1:1 and you will be trading without leverage. This will allow you to open trading positions with the exact amount of money needed and avoid the high risk that occurs due to leverage when the market reverses. Some brokers allow you to change your account leverage anytime you wish. On some platforms, you will specify your trading leverage along with the trade size before placing a trade and you may choose 1:1.
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