Ultimate guide about leverage in the forex market

What is Leverage in Forex Trading and Key Guidelines for Its Use?

Leverage is a compelling concept in the forex market that has made many people interested in investing in this market is leverage. Leverage empowers traders to multiply their account balance and seize profitable opportunities when they arise. While the use of leverage can significantly boost a trader’s profitability, it can also lead to substantial losses.

Keep reading to gain a deeper understanding of the role of leverage in financial markets.

Contents

What is leverage in Forex?

Leverage in the forex market is a tool that the broker provides to traders so they can trade several times their capital and balance.

Consider a trader with a balance of $1000, and the price of an ounce of gold is $1600. With their current balance, they can’t afford to buy an ounce of gold. However, with the aid of leverage, brokers can facilitate the purchase of gold ounces far exceeding the trader’s account balance.

For example, when a trader employs a leverage of 1000, their assets are amplified a thousand-fold, amounting to $1,000,000—a sum loaned by the broker. It’s crucial to note that the trader must not incur losses exceeding their initial balance, i.e., $1000. If they lose $1000, the broker will close all open positions and reclaim the borrowed money.

Therefore, using high leverage can yield substantial profits for traders, given that it’s used judiciously and in conjunction with effective capital management. Conversely, if risk and capital management are disregarded, even the slightest market volatility could wipe out a trader’s capital. Leverage is like a double-edged sword, and it depends on the skill of the person who uses it.

Read more: 12 golden tips for capital management in forex

Leverage in brokers

Brokers typically provide varying leverage ratios, which can depend on the specific broker you’re dealing with. They may establish particular rules concerning leverage based on the balance and conditions of your account. You might be wondering, “Why would brokers extend such credit to traders in the form of loans?” Let’s delve into that next.

The primary reason is that turning a profit in the forex market without leverage necessitates substantial capital, which most small traders may not have at their disposal.

Therefore, brokers provide conditions for small traders to trade in forex with less capital in the form of trading leverage. This way, even those with limited capital can engage in forex trading and potentially reap significant profits.

At Trendo Broker, leverage ratios range from a minimum of 1:25 to a maximum of 1:1000. The capital that Trendo Broker extends to traders via leverage is determined by the initial balance of the trader’s account.

Furthermore, Trendo Broker has implemented rules designed to safeguard its customers’ capital in high-risk scenarios. For instance, during critical situations such as the release of economic news, the leverage ratio of trading accounts is lowered to 1:100 to mitigate risk.

This approach ensures that traders can capitalize on market movements while maintaining a level of protection against potential losses.

Read more: What is the economic calendar in Forex? (How to use the economic calendar)

Connection between leverage and trading margin

Brokers receive a deposit from traders, which is called a margin. Brokers provide the capital they provide traders with leverage in the form of margin. This money isn’t deducted from the trader’s balance, but rather from the trader’s free margin. Once the transaction is closed, this amount is returned to the trader’s free margin, with any profit or loss accounted for.

The relationship between margin and leverage is reversed. As the leverage of an account increases, the required margin for trading decreases.

Let’s consider two traders, each with a balance of $1,000. The first trader’s account leverage is 1:100, while the second trader’s is 1:1000. If both traders decide to buy a 0.01 lot of the EURUSD currency pair, the first person needs $10 of free margin, and the second person needs $1 of free margin.

Therefore, the second person can open more trades, and the probability of his profit is higher.

Read more: What is margin in Forex?

In another example, suppose two traders in Trendo Broker have a balance of $1000 in their account. Therefore, according to the image below, they have $1,000 of free margin for trading.

The first trader has an account with a leverage of 1:100. The trader opens a gold buy transaction in his account with a volume of 0.5 lots. As you can see in the picture, a $962 margin was used for this trade. In other words, for 100 leverage, a $19.2 margin is needed for every 0.01 lot of gold purchased in Trendo Broker.

At present, the trade in question is yielding a profit, and the account’s free margin stands at $65.98. If the trader wants to calculate how many more lots he can buy in the gold symbol, he can divide his free margin by the required margin for 0.01 lot of gold purchase. As a result, with this free margin, the trader has the capacity to trade an additional 0.04 lots in gold.

The second trader has an account with a leverage of 1:1000. The trader opens a gold buy transaction in his account with a volume of 0.5 lots. As you can see in the picture, a $96 margin was used for this trade.

In other words, for the leverage of 1000 in Trendo Broker, a $1.92 margin is needed for every 0.01 lot of gold purchased. The desired transaction is currently in profit, and this account's free margin is $909.32.

If the trader wants to calculate how many more lots he can buy in the gold symbol, he can divide his free margin by the required margin for 0.01 lot of gold purchase.

Therefore, the trader can trade another 4.73 lots in gold with this free margin. Note that the higher the account leverage, the less margin is required for trading.

Why should leverage be used in Forex?

Indeed, the forex market typically experiences relatively minor daily percentage changes. For instance, the price of gold (XAUUSD) may fluctuate by a mere 2-3% in a day at best.

In such circumstances, without the provision of leverage, traders would require substantial capital to participate in the forex market. Consequently, the average monthly or annual returns for a trader would be quite low without leverage, diminishing the appeal of forex trading. So, leverage in the forex market is necessary.

It’s a crucial tool that enhances trading potential and keeps the forex market accessible and attractive to traders of all levels. However, it’s important to remember that while leverage can amplify profits, it can also magnify losses.

Important tips for using Leverage

More than 90% of retail traders lose in the forex market. One of the important reasons for this is using very high leverage in trades. Traders who use high leverage in their trades will eventually lose their accounts. Go to your user account and set the account leverage to a maximum of 1:200 after reading this article.

You might currently be in control of your behavior and not act emotionally, but there are moments in the market that mess with every trader's mind.

In such cases, if the leverage on your account is high, you might be tempted to increase your trading volume, which could potentially lead to significant losses. However, if your account leverage is capped at 1:100 or at most 1:200, you’re inherently limited in the volume of trades you can open. This restriction can serve as a safety net, minimizing the risk of depleting your account.

Trading with high leverage can indeed be a risky endeavor. While you might not experience losses immediately, the risk of substantial losses increases over time. It’s not a matter of if, but when. Therefore, it’s highly recommended to moderate your leverage.

By doing so, you can better manage your risk and potentially safeguard your account from significant losses. To better understand the process that takes place, we encourage you to read the following article.:

The next piece of advice is to test your strategy and skills on demo accounts before starting to trade with leverage in the forex market. These accounts allow you to engage in risk-free trading, providing a valuable opportunity to gain experience and confidence. With Trendo Broker, you can easily open a demo account and start your journey in forex trading.

Read more: Tutorial on Opening a Forex Account & Authentication in Trendo

Summary

In this article, we’ve covered virtually everything you need to understand about leverage and trading credit in the forex market.

Leverage is a powerful tool that enables traders to multiply their account balance and potentially reap substantial profits when the conditions are right. However, it’s important to remember that leverage also amplifies trading risks. Therefore, it’s crucial for professional Forex traders to have a thorough understanding of this concept and be well-versed in the risks associated with using trading leverage.

As a rule of thumb, we advise against risking more than 2% of your total capital on a single trade.