Leverage is an exclusive service provided by the dealing centers and Forex brokers. In fact, it is borrowing of money to increase profits from trading in the Forex market. Despite the name, leverage is not a traditional loan. A trader using this service is not obliged to pay an interest rate to a broker for its use. The principles of trading with leverage and making money with its help will be discussed further.
General description of leverage
Leverage is one of the reasons why Forex trading is so attractive and popular. With its help, traders are able to trade significant amounts exceeding their own deposit and to increase the initial capital several times in the short term.
How it works?
Traders use leverage if their deposit is insufficient to conduct a major transaction. Actually, the borrowed funds are not transferred to the account of a trader, but trading opportunities get increased. Consider the following example.
There is $1000 on a trader’s account. With a leverage of 1:100, he gets a chance to make trades of $100 000. Along with this, $1000 is blocked as a collateral.
Making transactions with 1 lot volume, a trader will receive $10 for every point the price moves in favorable direction. Without leverage, his income for one point would be $0,1. As it is seen, the difference is significant. However, a trader gets a loss in case of unsuccessful deal, which will be 10 times more than if he traded using only his own funds.
How to reduce the risks?
It is worth noting that trading with leverage, a trader does not risk to lose the whole deposit. If the amount of the loss is equal to the amount of collateral, the position is automatically closed. Therefore, a trader only risks his / her deposit and owns nothing to a broker in case of loss.
The greater leverage a trader uses, the more he risks his deposit. While opening a transaction excessing his deposit 500 times, he risks lose all his money for several seconds. Prudent management helps to prevent these outcomes.
The essence of money management is to establish an acceptable level of risks for each transaction. It is calculated as a percentage of total own funds. The optimal level of risk –is 2%. It means that a trader needs to consider that he can lose no more than 2% of a deposit during one deal even with the use of leverage. However, it decreases the cost of a point, which consequently affects amount of the potential profit.
There is also a possibility to use a stop-order in the Forex market, which allows traders to avoid bankruptcy. They will automatically trigger and close the position if price reaches the set limit, which is critical for a specific transaction. Value of a stop order depends on the method of capital management and trading tactics of a trader.
Thus, trading with leverage can be very profitable due to a reasonable money management and proper risk assessments.