Leverage in Forex

Jun 11 / VT Markets
What is leverage in forex ? Leverage trading is a way to increase your exposure to market forces when you deal in foreign currency pairs. The forex market works according to laws of risk and reward — the greater the risk, the greater the potential reward. Therefore, the higher the leverage rate, the higher the potential return. However, this also increases the potential loss.

When you leverage a forex trade, you essentially borrow capital to supplement your money. Forex currency pairs move in pips — pips in forex are minimal price movements, so un-leveraged positions can only result in small profits and losses. By borrowing additional capital for leverage, you increase how much each pip movement is worth.

For example, if you trade with a leverage of 1:10, you are borrowing $10 for every $1 you put forward, and each pip is worth 10x the amount it would be without leverage. You will still need to pay this $10 back once you close your trade, which will be taken out of the profits of a successful position. You’ll need to pay this amount back if your position fails. This is why traders must be cautious and ensure they take the time to learn forex techniques before extending the leverage on their positions.

CALCULATING THE LEVERAGE RATIO

Leverage is generally represented as a ratio — for example, 1:10. The number on the left of the ratio represents the money you will put forward from your capital. In contrast, the number on the right represents the proportion you will borrow. With a 1:10 trade, you can use $100 of your own money to control a position of $1,000. With a 1:100 trade, this $100 will allow you to control a position with $10,000.

It’s important not to get carried away with leverage trading. Stick to your strategy, and only choose a leverage ratio you feel comfortable with. Don’t be tempted to push the boundaries, and stick to manageable levels of risk.

HOW TO TRADE WITH LEVERAGE

The key benefit of forex leveraging is the profit potential, but you need a strong strategy if you are to stand a chance of realising this potential. This means understanding your risk tolerance and how much you are willing to borrow on your trade. Next, you’ll need to select a currency pair that best suits your strategy and choose a leverage ratio that aligns with your targets. Once these preliminary steps are complete, you can start to trade with leverage.

PUT PROTECTIVE MEASURES IN PLACE

Before opening your forex position, you need to have some protective measures. These tools will help you maintain a sustainable approach to trading and ensure that your position remains within strict parameters. The main tools you will use take profit and stop loss, and you may use these with other forex trading techniques such as FX futures.

TAKE PROFIT

Take profit will automatically close the trade once a certain profit level is reached. With forex trading, mainly leverage trading, you are not simply trying to achieve the maximum level of return from each position. Instead, you want to ensure that your profits remain within your broader strategy. This tool helps ensure your profits don’t reach unsustainable levels and you stay on track for long-term growth.

STOP LOSS

Stop loss works the same way as taking profit but in the opposite direction. This tool enables you to set a loss limit. If your position struggles and falls to this limit, it will automatically be closed, and you will absorb the losses. The tool ensures that losses do not become unmanageable and helps you keep within the initial strategy’s limits.

OPEN YOUR POSITION

Once you have chosen your leverage ratio and set your take profit and stop loss tools, you can open your position based on the current spot trading price. Open a buying position if you believe the currency pair’s value will increase, or open a selling position if you think it will fall in value. You should have a strategy for how long you expect to keep the position open.

CLOSE YOUR POSITION

When you reach your predetermined endpoint for the position, you can close it. This means the position is no longer exposed to market forces, and you will take any profits and absorb any losses incurred while it remains open. You now need to pay back the capital you leveraged on the position, whether you made a profit or not.

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