i. Leverage is a kind of loan brokers give to traders.
ii. In forex trading, leverages can go up to 1:500.
iii. Leverage can have a lot of advantages but there are lots of downsides to it too.
What is Leverage?
Leverage is money that a trader borrows from brokers. With leverage, the trader can control a larger amount of the market with a small initial deposit.
When a trader uses a leverage of 1:100, then with $1000 in the account, that trader can control $100,000.
Let's try to understand this with the help of an example, lets consider, you funded your trading account with $1000 and your broker provides you no leverage so, you have to trade with leverage of 1:1.
This means that with a $1000 account you can control only $1000 i.e buy or sell only 1000 units of any currency pair.
Now, let's say that you bought 1000 units in USDJPY, which means you used a lot size of 0.01. Let's consider you bought 1000 units in USDJPY at 110.000 and then the price moved to 111.000.
This means that the price moved 100 pips. This means that you had a profit of $10. which is 1% of your account.
Now, let's consider that you had the leverage of 1:10, this means that with a $1000 account you can control $10000. This means that your broker allows you to use 10 times of your account.
You now bought 10000 units in USDJPY at 110.000 and then the price moved to 111.000. That is a movement of 100 pips. So, now with leverage of 1:10, you made a profit of $100, which is 10% of your account.
So, in simple terms, leverage means borrowing from your broker. For a $1000 account, the leverage of 1:10 gives you 1000x10= $10000, allows you to buy/sell 10000 units i.e you can use a lot size of a maximum of 0.10.
Leverage of 1:100 gives you 1000x100=100000, lets you control $100000 and allows you to buy/sell 100000 units respectively i.e you can use a lot size of maximum of 1.00
Now, you may be wondering, why does your broker let you borrow the money and how can it benefit the broker?
Well, there is a very simple answer to it. Your broker earns money when you trade more and therefore your broker wants you to trade more.
Plus, the broker keeps your initial deposit aside, and as soon as your trading account is in loss nearing your initial account balance all of your trades are closed.
For, example lets say you, had the leverage of 1:100 on your $1000 account and you entered a buy trade on USDJPY at 110.000 with a lot size of 1.00 (you bought 100,000 units) and the price moved to 109.000 this means that you had a loss of 100 pips.
So, now as your account was in loss of $1000 your account will get flushed that is, all your trades will be closed with a loss of $1000, making you lose 100% of your account on a single trade.
You can see leverage is a double-edged sword, that is it can double your account in a trade but it can also make you lose your account in a single trade.
Advantages of Leverage
1. Greater profits
The only reason why leverages exist in the forex market is that they let traders increase the scale of their profits.
A trader can easily maximize his profits when he uses larger leverage as it can allow them to control a larger amount than deposited.
For example, a trader who has just $1,000 in their account can trade for about $5,00,000 while using the leverage of 1:500.
With leverage, a lot of small investors with small accounts get the opportunity of maximizing their profits when they are having a profitable day.
2. Beneficial for beginners with small accounts
Using leverage can be very beneficial for someone new to forex trading.
I believe that demo trading is way different from real trading, a new trader needs to practice their strategy on a small real account before they start trading with a large account.
Without leverage, practicing on the small account can be a very annoying and slow process as you won't be able to grab more than one opportunity at a time with a small account size and no leverage.
So, leverage allows a newbie to practice on real accounts using small account sizes and high leverage.
Disadvantages of leverage
1. Greater losses
As people say that the leverage is a double-edged sword. It is true. Yes, you can make a lot of money using high leverage but also you can have greater losses while using high leverage.
Nothing is guaranteed in forex, everything is just a probability.
As there are chances of winning a trade there are the same chances of losing a trade.
So, when a trader has a bad trading day, or when they have losses, high leverage can work against them and make them lose their account or a high percentage of the amount from their account.
2. Margin call risk
Every broker has margin limits for each set of leverage and as the value of your trades falls below your total margin, the broker automatically closes all your trades and you lose your account or the amount at risk with the respective leverage.
Ultimately, this is a constant risk that is posed by the presence of leverage, and something you should take care of managing your capital to avoid.
Types of leverages provided by brokers
There are different leverages provided by different brokers in the forex market. Some provide leverage of 1:50 to 1:500 and few brokers provide you the leverage of 1:1000.
The most common leverage provided by forex brokers ranges from 1:1 to 1:500.
How to use leverage?
I personally use the leverage of 1:50 for my big-size accounts and 1:250 for my small-size accounts (challenge accounts).
Professionals mostly use the leverage of 1:10 to 1:50, as, their account size is that big to let them use that leverage.
For someone who is new to forex and wants to try trading real accounts with small accounts as low as $50, they can use a leverage of 1:100.
Because with an account size of $50 you cannot use the leverage of 1:10. You won't even be allowed to open a trade with that leverage.
So, for accounts from $50-$5000 the leverage of 1:100 is appropriate, for accounts from $5000-$10000 or more you can use the leverage of 1:50, just make sure you use a stop loss and don't risk more than 3-5% on a single trade.