Leverage is a concept used in the world of investing, including forex trading.
It’s a tool that allows you to make large trades without putting up a lot of money upfront. It’s a way to make a trade with only a fraction of the money that you’d need to invest if you didn’t use leverage.
Here’s a closer look at leverage and how it works in forex trading.
What is Forex Trading?
Forex trading is when a trader buys a currency and sells a different one, and the exchange range fluctuates according to the demand and supply. The trade for currencies takes place in the foreign exchange market that is open from Monday to Friday.
The Foreign exchange market is open 24 hours a day. All currencies are traded over the counter (OTC), which means there are no physical exchanges, and a worldwide network of financial institutions and banks oversee the operations. As a result, the vast majority of trading in the market is between institutional traders.
Leverage in Forex Trading
In the past, only large financial institutions and wealthy individuals were allowed to invest in the Forex market. The main reason for this was that a large amount of capital needed to be invested by the trader. Retail traders usually lacked large capital, which is why they were unable to invest in Forex.
Why is Leverage Required in Forex Trading?
Due to the internet and other means, it is easy to access the Forex market nowadays for traders. The daily trading value at Forex has also increased significantly over the past ten years. As a result, it has also increased the total number of retail traders in the market.
The availability of derivatives, such as CFDs (Contract for differences), allows traders to speculate the rise or fall in the value of currencies without owning the underlying asset. Leverage in the Forex market is important for derivative trading, as it allows traders to enter the market with a small capital amount.
For example, if a trader needs 100,000 dollars to enter the market with leverage, the amount can fall to just 1,000 dollars. Leverage has allowed all types of investors who previously couldn’t invest in the Forex market to enter the market.
How Does Leverage Work in the Forex Market?
Leverage in financial terms is expressed as a ratio (1: 1, 1: 10, 1: 100). The amount of leverage and the size of the initial investment by the trader determine the size of trade they will be able to control. For example, if a trader initially invests 1,000 dollars, the levels of leverage will have a varying effect on the size of the trade.
| Leverage | Size of Trade |
| 1:1 (no leverage) | 1,000 dollars |
| 1:5 | 5,000 dollars |
| 1:10 | 10,000 dollars |
| 1:20 | 20,000 dollars |
| 1:50 | 50,000 dollars |
| 1:100 | 100,000 dollars |
As you can see in the table, the higher the leverage in play, the larger the trade size for the trader. Thus, even though using leverage has several positives, it is still a risky move for the trader. To understand how leverage can lead to losses and profits, traders must understand margin, and we have discussed the concept below.
Margin
Margin is the deposit the trader needs to pay to use leverage in the Forex market. This amount should already be present in the trader’s account and will be reserved once they open a trade using financial leverage. The amount of the margin that is required depends on the trade and the leverage.
For a standard lot, which is 100,000 dollars, the required margin will change. Please study the table below:
| Leverage | Required Margin |
| 1:1 | 100 % |
| 1:5 | 20 % |
| 1:10 | 10 % |
| 1:20 | 5 % |
| 1:50 | 2 % |
| 1:100 | 1 % |
As you can see in the table, the higher the leverage, the lower the margin required for a trader to enter the market. So, if a trader wishes to open a market position of one standard lot (100,000 dollars) using leverage (1:50), a deposit of 2,000 dollars would need to be paid as the margin.
Pros and Cons of Leverage in the Forex Market
As we have already discussed, leverage has many benefits for retail traders in the Forex market, especially for those traders that don’t have much capital to invest. However, even though leverage can increase profits, it comes with risks and results in huge losses for the trader.
Traders that enter the Forex market low on capital and overleveraged can see their investment vanish if there are fluctuations in the market. The margin needed for financial leverage can also eat up the investment if the trader opts for high financial leverage and invests only a small percentage of the total capital. If a trader is stuck in this scenario, it is a dangerous position, as if the market moves in a negative trajectory, the trader will lose all the investment. Therefore, it is important for traders entering the Forex market to be cautious and understand margin and leverage thoroughly.
New traders should also have prior knowledge of how the Forex market works before they invest. Some traders also implement a sound risk strategy, which is leverage based on the capital available.
Experts advise new traders to start with a demo account before investing their own money, enabling them to understand the market without risks better.
The Risks of Forex Trading
Forex traders require leverage, and traders will also use margin, so there are risks involved. Currency prices fluctuate but not by a huge margin, so traders often need leverage to execute a trade. If the trader makes a winning bet, the leverage can help maximize the profits.
However, the leverage can also increase the losses. If the value of a specific currency falls significantly, traders that rely on leverage open themselves up to margin calls, which can force them to sell off their securities. Other than losses, transaction costs can also reduce the profit.
To become a successful Forex trader, you need to be skilled and extremely sharp, as there are many obstacles, and the risk of fraud and misinformation is high.
Forex Trading Frequently Asked Questions (FAQ)
- Who owns Forex, and where is it located?
Forex does not have a particular owner; it is an interbank market, which means transactions occur between a seller and a buyer. Therefore, as long as the current banking system exists, Forex will exist as a specific government or country that does not run it.
- Working Hours of Forex?
Forex opens at 22:00 GMT on Sunday (Australian trading session opens) and closes on Friday 22:00 GMT (US trading session closes)
- How Much Money is Needed to Start Forex?
Some traders start trading with just a dollar; however, the starting amount varies from 100 to 100,000 dollars.
- Best Strategy for Forex?
No one strategy is better than the other one; traders must develop new strategies all the time. Some Forex strategies are only beneficial in the short term.
- Can I Lose more than What I Invest in Forex?
Not really; the broker will not let the trader face huge losses and will not allow the loss to be greater than the amount in the trading account.
Conclusion
In this article, we have thoroughly discussed what leverage means in the Forex market, and along with that, we have shared crucial details regarding margin. Both margin and leverage are key concepts, and traders need to be aware of them.
However, we have shown both sides of the coin; we’ve discussed the pros and cons of using leverage in the Forex market, and traders should be cautious before using it. The main benefit of leverage is that it allows all types of traders to invest in the Forex market, even those with low capital.
If traders can analyze the risks and develop a suitable and sustainable strategy, they should use leverage to trade.