Leverage CFD & Forex
One of the main advantages of trading on the Forex is a feature characteristic to the foreign exchange market known as ″leverage″. To help you better understand leverage, here is an explanation of its functions and advantages.
The Advantage Of Trading With Leverage?
Leverage provides a precious advantage that is not found in other stock or financial markets, as it offers significant returns on investment.
To clarify, while executing forex trades with margin (also called leverage trading), it is not necessary to invest the total amount at the time of the transaction.
Thanks to leverage, positions can be held that are superior to the actual investment amount. Some trading platforms will propose a figure equal to about 400 times the initial investment, although most will offer a value of 1:100 or 1:200.
Why is leverage a classis characteristic of the forex market?
This forex feature can be explained by way of the weak variation in the exchange rates (degree of volatility) that rarely exceeds 1%, where the market rates will instead show changes ranging on average between 5 and 10%. By definition, this renders the Forex a market with a strong leverage effect.
Leverage is better understood by analysing the gains that are possible via an investment of thousands of dollars. Variations of one cent, although regarded as a significant movement, will not equate to considerable profits.
Leverage allows us therefore to increase the amount we have to play with and consequently, our earnings, without having to invest hundreds of thousands of dollars. This, at least, makes the market more accessible. Take note also that it is very difficult to start a transaction inferior to €100,000.00, since currencies are traded in lots, even though some brokers offer the option of smaller lots, over a period of time, to allow individuals to also take advantage of the currency exchange rates.
How Does It Work?
In order to understand the interest in using leverage on the Forex, here is a concrete example of how to use this tool:
If we have €1,000.00 available, we could buy a lot of 100,000 EUR/USD. In fact, applying leverage of 100:1, would be like multiplying the account on a margin of €1,000.00 per 100.
In this type of scenario, if the purchased lot was initially priced at 1.5270 and we sold at 1.5500, the profit would not be €23.00, but €2,300.00.
Inversely, if the price of the lot were to fall to 1.5200, there would be a loss of €700.00.
Precautions to take when trading with leverage:
When using leverage, the investment is multiplied and consequently so too is the earning potential. Having said that, leverage must be used wisely in order to avoid losing large sums of money.
For example, in the case of losing 60 pips on a lot and the margin account having insufficient funds to meet this possible loss, the broker will request a margin call, which means it is necessary to replenish the margin account by adding more funds. If the trader does not comply, the broker will close the position and the trader will lose 50% of the initial capital. It is therefore essential to manage the strategy wisely taking into account this leverage and using multiple orders simultaneously, like the If Done orders or OCO orders.
Important to note:
Margin and leverage are two entities that are interdependent. When trading in Forex, margin serves as a guarantee in the case of a leveraged trade. The margin rate is determined according to various parameters set by the broker. These are called margin requirements.
Thanks to this specific margin, it is possible to create leverage on a trade. To summarise, the margin amount determines the value of the leverage and the leverage actually determines the margin.
Leverage must be used with caution, since it allows for large profits but also runs the risk of huge losses. It is advisable then to start trading with modest leverage to test the market. Later, you can increase the leverage if you see that the market is working in your favour.