Most brokers these days advertise leverage as one of the selling points of opening an account with them. In simple terms, leverage in the Forex world refers to the ability to control large trading volumes with a small investment. It is commonplace to find brokers advertising leverage of 100:1. Simply put, this means that for every dollar you deposit you can trade $100.

In this example, the broker is saying that he will ‘lend’ you the money to make your trade, if you put forward 1% of that trade as a security against it. That 1% is called a margin: the percentage of the total trade required as collateral. This 1%, when expressed as leverage becomes 100:1 (a security of 1 is required for every 100 traded). Some brokers offer even greater leverage, such as 200:1 and 400:1 (which expressed as margins are 0.5% and 0.25% respectively).

So, by using leverage it is possible to fund an account with just $1000, and you could control trades valuing up to $100,000 (assuming the leverage is 100:1). This almost sounds too good to be true, especially for someone new to Forex who has a relatively small amount to begin trading with.

Everything you have read so far on leveraged trading is true, and traders are using leverage as a way of controlling large sums with small margins. There are also traders however, that have fallen foul of relying too heavily on leverage in their trading and lost more than they bargained for. And so we come across a case of ‘Caveat Emptor’!

What many new traders who fall for the allure of leverage advertised by brokers don’t realise, is that the quoted leverage available is the maximum leverage allowed on your account. You don’t actually have to use all of it. In fact, it is best to use as little as you can, because the more leverage you use, the more you are at risk from fluctuations in your trade value.

Going back to our example using a 1% margin to buy lots to the value of $100,000 (leveraging your $1000 by 100%). You now have open trades worth $100,000, but only a breathing space of $1000. If your lots fell in value by a mere 1%, your $1000 would be wiped out and your broker would make a ‘margin call’ (this means some or all of your trades would be closed automatically).

You may want to put in place a stop loss to prevent this happening, further narrowing your breathing space somewhat. Then we have the spread put in place by your broker, now you find youself with very little room to manouvre. Sure, your lots may increase in value, even by enough to make a profit after the spread. However, Forex markets can be volatile and your lots could easily dip below your stop loss before turning around and becoming profitable. Because you were too heavily leveraged, your trade closed at a loss because you had no room to breathe.

Sensible traders will not leverage their accounts too heavily. Instead of taking the maximum 100:1 on offer, a much more level-headed option would be to take say 20:1 (which would be a 5% margin). Now I am not suggesting that taking an account you have funded with $1000 and putting it all at risk on the same trade is a good idea, but doing so with a 5% margin now gives you more breathing space.

With this example, you would now control lots to a value of $20,000, and they would have to fall by 5% in value for your broker to make a margin call. You can now place a stop loss that gives you room for a possible dip without your trades closing out before they turn into profit.

Leveraged trading will always be a useful tool to allow traders to increase their capacity to trade, but for the inexperienced trader it can be a hard lesson in how a small movement in the market against you could be disastrous. When used correctly, a leveraged account gives the average man in the street the opportunity to trade in lots that would have otherwise been out of his reach. The important things to remember when using leverage is that you should not allow your account to become too heavily leveraged and that it should be used as a tool to give you an advantage in the market, not your broker.

Quick And Easy Forex Trading is an essential tool for anyone trying to learn to trade Forex profitably. It covers all the topics you need to know about, along with some very useful forex trading tips to help you kick-start your trading career.

To get a free chapter from Quick And Easy Forex Trading, simply fill out the form on the right of this page. Thank you.