Leverage is the biggest reason why so many retail traders are drawn to the Forex market in the first place.
We know you heard about this before, but this topic is so important for a newbie, we felt the need to discuss it again.
The forex market has become a bit of a breeding ground for ‘the get rich quick marketeers’ and the so-called gurus out there. And leverage is the main enticement they use.
What is Leverage?
Leverage is the ability to control a large amount of money using none or very little of your own money and borrowing the rest. Basically, it’s a loan from the broker that will allow you to have a bigger exposure in the market.
For example, if you deposit $1,000 into your brokerage trading account, he can allow you to trade a $100,000 position. Bigger position and exposure means bigger profits (but also your losses can be greater).
How life would be without leverage? Let’s take a look:
Let’s say that you have $5000 in your trading account and want to buy Amazon or Apple or Facebook stocks. At the time of writing this blog, you’d be able to buy 43 shares for Apple, 18 shares on Facebook and just 1 share in Amazon.
If these companies will have a tremendous 5% rise, this will give you 500$.
Can you imagine? Only $500, but this is life without leverage.
How is life with leverage in the Forex market?
For the same $5000 account, leverage of 50:1 will allow you to control 250.000 units, of the base currency.
The buying or selling of a Forex contract is done in terms of lots, and a standard lot represents 100,000 of the base currency.
For example, the EUR/USD has the pip value equal with $10. If you’re using a 50:1 leverage on the $5000 account, you’re controlling 250.000 units of the base, that would equate to two and a half lots. You’ll trade 2.5 lots with a 5,000 account if I’m using 50:1 leverage.
20:1 leverage is basically 100.000 units. That would equate to one standard lot. So if a trader is using one standard lot on a $5,000 account, that’s basically using 20:1 leverage.
How leverage works?
As I always say, when you’re trading the markets, you should always have a predetermined amount that you prepared to risk on each and every trade.
Let’s assume we’re going to risk 1% of the $5000 account on each trade. 1% of $5,000 would equate to 50 bucks. So you’re prepared to risk $50 only by using the 1%.
- Using 50:1 leverage, you’re trading two and a half lots.
- Each lot is worth $10 per pip, that means the pip value is $25.
- You’re allowed just 2 pips wrong then you’re stopped out.
- 20:1 leverage controls 100.000 which is one standard lot.
- 1 lot = $10 per pip. You’re only allowed five pips and you’ll be stopped out and lost your 1% on the account.
- 5:1 leverage controls 25.000 units which are equal to 0.25 lots.
- the pip value will be $2.5, so you’ll be able to lose 20 pips before your stop loss is hit.
The more leverage you use, the more risk you’re taking and it’d be more likely to get stopped out. Risk and leverage go hand in hand, and you need to be certainly aware of that.
Some of the brokers offer massive leverage in order to entice you in.
100:1, 200:1, 500:1 and even 1000:1.
Imagine that, the $5000 account using 500:1 leverage controls $2,500,000. If the 1% you’re risking moves up or down, you could lose or win $25000 depending on the currency pair. That means 20 pip in wrong and you could blow your $5,000 trading account.
The good news is that recently a lot of the regulations are forcing brokers to offer lower leverage. It started off in Japan a few years ago and they’ve reduced their permit to leverage to 20:1 only. In the U.S. current maximum leverage, you can trade is 50:1. ESMA (European Securities Markets Authority) reduced their permitted leverage to just 30:1 on the major pairs.
It’s definitely a concerted effort in the industry to protect customers such as yourselves. This huge leverage can be great in times when the markets are working for you, but it’ll blow you out of the water when it goes against you.
That is the power and the danger of leverage. It can work for you or against you.
As always if you liked this blog, leave a comment below. Until next time happy trading and good luck! I hope to see you in the Trading Room.