Flip Side of Leverage in Forex
Leverage means borrowing some amount for investing. In forex you can borrow the money from your broker. Leverage is quite high in forex trading with margin requirement. The margin-based leverage can be calculated dividing the total value of the transaction by the margin.
If you need to deposit, say, 1% of the transaction value as margin and you wish to trade one standard lot of USD/CHF, which is equivalent to $100,000, the margin would be $1,000. You are offered a leverage of 100:1 (100,000/1,000).
However, real leverage has got more impact on an investor’s profit and loss. It can be calculated by dividing the total transaction value with total trading capital. If you have $10,000 in your account and you open a $100,000 position you are trading with 10 times leverage (100,000/10,000). Real leverage is different from margin-based leverage.
Transactions must be carried out in big volume in forex to take advantage of the small incremental changes. For making a decent profit the traders must use a high leverage. You have the freedom of having real leverage on the basis of trading style and money and risk management preferences.
But excessive real leverage has a flip side too. It increases your profit and your losses by the same degree. The greater the leverage on capital, the higher the risk! A highly leveraged trade can quickly affect your trading account in a negative way. Maintaining a strategy to limit the loss is extremely important. But, because the spot forex market’s volume and liquid, it is easy to enter and exit a trade. You may decide to never risk more than 2% of your trading capital on any one trade.
There are other factors that are to be considered as well. If, for example, USD/CAD is having a daily range of 70 pips and each pip is worth nearly $10, you can risk only 20 pips (2% of $10,000 = $200, 1 pip = $10; $200 = 20 pips.) You must place a stop loss at 20 pips. But this has to be placed in a place where it is unlikely to be hit by the continuous fluctuations that can cause losses for you at every instance it hits the stop. For all these you must formulate a strategy beforehand.
Tags: forex, forex leverage, forex trading