What is leverage?
Leverage is nothing but the money that a trader borrows from his broker to increase his profit potential. It means that a trader can control a larger amount of the market with a small initial deposit. Technically, when a trader uses the leverage of 1:100, it means that with $1000 in the account, that trader can control $100,000.
Let us try to understand this with the help of an example, let us 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 USD-JPY, that means you used a lot size of 0.01. Let's consider you bought 1000 units in USD-JPY 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. that is 1% of your account.
Now, let us 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 USD-JPY 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, that 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 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 let's say you, had the leverage of 1:100 on your $1000 account and you entered a buy trade on USD-JPY 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 clearly 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 him/her to control a larger amount than deposited.
For example, a trader who has just $1,000 in his 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 who is new to forex trading. We believe that demo trading is way different from real trading, a new trader needs to practice his/her strategy on a small real account before he/she actually starts 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 small account size and no leverage. So, leverage allows a newbie to practice on real accounts using small account size 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 trade there are the same chances of losing a trade. So, when a trader has a bad trading day, or when he has losses, high leverage can work against him and make him lose his account or a high percentage of the amount from his 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 there are few brokers who 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?
We personally use the leverage of 1:50 for our big size accounts and 1:250 for our 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 account with small accounts as low as $50, he 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.
Many people fear to use leverage and we that know a lot of ill talking has been done about this topic. But honestly, there is no need to worry about it. Every trader uses leverage and it is important to use it if you want to see growth. It's just that one must understand how much leverage to use based on the different conditions in the market.
It's good to use small leverage if you have a huge trading account and its equally good to use large leverage ranging from 1:100 to 1:500 or even more if you have a small account size. What's important is the way you manage your leverage and the way you manage your risk.
If you are using larger leverage make sure you use a proper and realistic stop loss which will minimize the total risk of your account and always remember to use a stop loss when your leverage is too high because in the end, you can make money in forex as long as you have money in your trading account