Leverage is now an integral part of the foreign exchange market. The term essentially means borrowing and the accessibility of cheap credit has enabled the fx market to grow significantly in the last few years.
Leverage is considered a mixed blessing in the forex market, as it typically amplifies both profit and loss. This is particularly the case in areas of the market where large-scale leverage is the norm.
For example, in the US, leverage can be utilised in the foreign exchange market at a ratio of 50:1. Therefore, for every $1 invested, another $49 can be borrowed, enabling the trader to buy $50, or fifty times more currency. This means fifty times more profit when a trade is successful, but similarly, if the trade does not go the investor’s way, it could mean a loss fifty times higher.
Things to remember when using leverage
It can be difficult to resist the possibility of making large profits using only a small initial deposit. However, high leverage can also result in the trader losing much more than just a few dollars. Therefore, it is recommended that when trading, you take measures to negate at least some of the risks involved.
Place a cap on your losses
Unless you do this you will very quickly see your equity disappear as your losses get out of hand.
Conditions within the forex market can change very quickly. By placing stops on your trades you can not only minimise loss, but also protect profit.
Cut your losses
As the saying goes, if you start to make a loss, under no circumstances should you continue to add to the position in the hope that a miracle will reverse the loss and bounce you back into profit. This will only serve to exacerbate the problem and losses will spiral out of control.
Comfortable leverage limits
Ensure you are at ease with the leverage levels you are using. In recognition of the high risk that extreme leverage potentially poses to traders, the US has now set maximum limits on leverage. For major currency pairs this is 50:1 while for all other pairs the limit is 20:1. However, it is not unusual to find brokers internationally who are offering credit of up to 400:1. Operating at such high leverage to margin ratios can erase all your equity in the event of a relatively small downturn. Leverage of 10:1 or less is considered a more sensible level.