The Intelligent Guide To Using Leverage In The Forex Market
For retail forex traders that participate in the market from the level of a home
investor and not at an interbank level, leverage might not be a difficult concept to understand but using it in a proper and intelligent way can be much more difficult. In the global foreign exchange marketplace, nearly 95% of all market activity is speculative in nature, and because it is big banks and financial institutions that rule this market most of this price action is highly leveraged in nature. Understanding the nature of this financial process, why it exists at all, and learning how to use it in an intelligent manner without unnecessarily large risks can be the difference between failure or success in your trading career.
Why Does Leverage Exist In The First Place?
Leverage in forex trading is the ability to control a much larger amount of money using a much smaller amount of money, meaning that the gains and losses experienced on your trades are greatly magnified. As a retail forex broker, this means that the difference that you earn on the bid/ask spread when a trade is placed (or the difference between the buy and sell prices for a certain currency pair) is also magnified by the amount that is being leveraged.
For people who are newcomers to this market and maybe do not have a refined trading strategy or do not know how to properly manage money in a highly leveraged trading environment, granting them access to such high amounts of leverage can be kind of like giving them more rope with which to hang themselves. Whenever you enter into an open position you will automatically need to gain a few pips in order to simply break even, and this is literally the amount that is paid to the broker for making the market available to you for trading (hence the term 'market maker').
If we take the popular example of the GBP/USD currency pair, let's say we are trading 2 standard lots at 100:1 leverage with a 4 pip spread. In this setup one pip would be worth $10 for every standard lot that is traded, so if you are trading with two lots and you enter into an open position you would automatically be down $80 and that is the amount that gets paid to the broker for providing liquidity. A normal amount to fund an account for this type of trading would be $5,000 - $10,000 in order to provide a buffer for any potential account drawdown without the risk of a margin call, and if you are a trader that has little experience then you would be paying a disproportionate amount of your trading capital in the form of commissions due to the high leverage rate. Remember that if you were trading at 1:1 and not 100:1, the commission would be $0.80 and not $80.
How To Use Leverage Intelligently Without Unnecessary Risks
Depending on your forex trading platform, you might be able to control your leverage percentage with the click of a mouse, or it might be a fixed amount that you agree upon when you sign up for the account. The first step you will need to take is to make sure that you give your account sufficient initial funding, otherwise a string of losing trades when you are just starting out could wipe you out completely. And as always, do not anticipate on losing money but make sure that it is money that you do not need to pay bills with otherwise your emotions of greed and fear will own you.
A good percentage to stick with is no more than between 10-20% of your trading capital being committed to an open position at any given time. One of the biggest mistakes new traders make is to surpass this percentage and put themselves at risk of massive account depletion as well as a possible margin call situation where you are forced to exit the market prematurely. The most important rule for using your account leverage in an intelligent manner is to keep things under control by not overextending yourself, and to allow gains and losses on your account to happen slowly by continually trying to hit 'singles' every time instead of going for a 'homerun' and then striking out with a massive loss.
by: Ricky Weber
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