Forex Leverage: A Double-Edged Sword

One of the reasons why so many people are attracted to trading forex compared to other financial instruments is that with forex, you can usually get much higher leverage than you would with stocks. While many traders have heard of the word “leverage,” few have a clue about what leverage is, how leverage works and how leverage can directly influence their bottom line.

What Is leverage?

To calculate margin-based leverage, divide the total transaction value by the amount of margin you are required to waterput up.

For example, if you are required to deposit 1% of the total transaction value spil margin and you intend to trade one standard lotsbestemming of USD/CHF, which is omschrijving to US$100,000, the margin required would be US$1,000. Thus, your margin-based leverage will be 100:1 (100,000/1,000). For a margin requirement of just 0.25%, the margin-based leverage will be 400:1, using the same formula.

However, margin-based leverage does not necessarily affect one’s risks. Whether a trader is required to waterput up 1 or 2% of the transaction value spil margin may not influence his or hier profits or losses. This is because the investor can always attribute more than the required margin for any position. What you need to look at is the real leverage, not margin-based leverage.

To calculate the real leverage you are presently using, simply divide the total face value of your open positions by your trading capital.

For example, if you have $Ten,000 ter your account, and you open a $100,000 position (which is omschrijving to one standard lotsbestemming), you will be trading with a Ten times leverage on your account (100,000/Ten,000). If you trade two standard lots, which is worth $200,000 te face value with $Ten,000 te your account, then your leverage on the account is 20 times (200,000/Ten,000).

This also means that the margin-based leverage is equal to the maximum real leverage a trader can use. And since most traders do not use their entire accounts spil margin for each of their trades, their real leverage tends to differ from their margin-based leverage.

Leverage te Forex Trading

This is why currency transactions voorwaarde be carried out te big amounts, permitting thesis minute price movements to be translated into gepast profits when magnified through the use of leverage. When you overeenkomst with a large amount like $100,000, petite switches ter the price of the currency can result ter significant profits or losses.

When trading forex, you are given the freedom and plasticity to select your real leverage amount based on your trading style, personality and money management preferences.

Risk of Excessive Real Leverage

Let’s illustrate this point with an example (See Figure 1).

Both Trader A and Trader B have a trading capital of US$Ten,000, and they trade with a broker that requires a 1% margin deposit. After doing some analysis, both of them agree that USD/JPY is hitting a top and should fall te value. Therefore, both of them brief the USD/JPY at 120.

Trader A chooses to apply 50 times real leverage on this trade by shorting US$500,000 worth of USD/JPY (50 x $Ten,000) based on his $Ten,000 trading capital. Because USD/JPY stands at 120, one pip of USD/JPY for one standard lotsbestemming is worth approximately US$8.30, so one pip of USD/JPY for five standard lots is worth approximately US$41.50. If USD/JPY rises to 121, Trader A will lose 100 pips on this trade, which is omschrijving to a loss of US$Four,150. This single loss will represent a whopping 41.5% of his total trading capital.

Trader B is a more careful trader and determines to apply five times real leverage on this trade by shorting US$50,000 worth of USD/JPY (Five x $Ten,000) based on his $Ten,000 trading capital. That $50,000 worth of USD/JPY equals to just one-half of one standard loterijlot. If USD/JPY rises to 121, Trader B will lose 100 pips on this trade, which is omschrijving to a loss of $415. This single loss represents Four.15% of his total trading capital.

Refer to the chart below to see how the trading accounts of thesis two traders compare after the 100-pip loss.

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