Forex Leverage: What exactly is leverage?

Forex leverage is a form of accumulating capital for use in trading. Usually, you would simply take the money out of your own pocket, deposit them to an exchange, and then proceed to trade. So, what is leverage in Forex? With leverage, you use the money borrowed from the broker, while your own money is often just a fraction of the overall capital.

A lot of brokerage providers allow their users to take leverage, although details and parameters vary from one to the other. Trading this way, however, is often very unsafe. If you lose completely, you’ll accumulate a crippling debt. That’s why big leverage (like 1:1,000) trades aren’t advised.

How does Leverage work?

Forex Leverage: What exactly is leverage?

Providing Forex leverage is a common practice. You can borrow money from nearly any worthwhile broker online. However, you’ll also have to register a special margin account on most occasions. The margin account is a special account within a system that allows you to monitor and manage your leveraged funds and trades where they participate.

Depending on a broker, the maximum leverage can be anything from 1:5 to 1:10,000. The bigger leverages, however, are only advised to seasoned traders who know what they’re doing.

The ratio means your money in relation to the money you borrowed. It’s called leverage because the borrowed amount usually outweighs the amount you contributed.

How is it useful?

It’s extremely dangerous, but leverage trading has several undeniable benefits:

  1. You are able to make trades without risking your own money.
  2. It allows you to increase your trading capital at the broker’s expense.
  3. It enables you to make bets if you’re about to receive more money but don’t have it at the moment.

Since profits are often proportional to the amount of money you deposited, you can borrow a larger sum of money than you have at the moment, then invest them, rip the benefits, and simply return the borrowed amount. This way, you’ll only have to part with a small fraction of your winnings. It’s a very alluring thought.

As for the third benefit, it’s a clever trick. If, say, you’re about to receive $1,000 in salary next week but see a promising trade right now, you can borrow the same amount from the broker. If it fails, you’ll be able to repay the broker with the funds you’ll receive soon. If it succeeds, you’ll be able to use this money to repay the debt.

Either way, you get the profit early.

The dangers

Although the chance to get some profit without really spending any of your money is pretty tempting, leverage trading is also very dangerous. This practice is called trading on margin, and the most common way of spending your money is shorting a stock. In short, it works like this: 

  1. You borrow a stock (represented by a money value).
  2. You wait for it to drop in price.
  3. You buy back the stock when it’s cheaper.
  4. You return the borrowed stock.
  5. You keep the difference.

That’s a common practice of speculating on the prices, mainly that it will fall. However, if instead it grows in price, you’ll be in trouble. You’ll have to either buy the stock at a higher price and lose money or wait for it to drop again. All the while, your interest will grow, meaning you’ll have to pay extra over time.

And if you don’t short, but instead borrow pure money to trade long instead (speculate on the price growth), you’ll be even more in danger. Margin trading demands you leave a portion of overall capital in maintenance, meaning it can’t be touched at all otherwise it’s your head. So, you’ll have to deposit more than you actually need.

Pair it with the increasing interest, a looming change that you can be double-crossed by a broker, and other dangers, and you’ll get a very risky type of trading. Only people with money in reserve and a lot of experience should trade on margin.

Trading with leverage intelligently

If you must trade with Forex leverage, then you need to take precautions because you can easily assemble a massive debt making wrong decisions. So, when taking this risk, you need to be very careful.

Firstly, have some money saved in reserve. That’s a very good general advice. Whether you need to do a quick trade or partially pay back a debt, a reserve will be very helpful. This may seem to defeat the point of leverage trading because the whole point is not to spend your money on trades. However, if you treat your reserve as an untouchable last resort, then it won’t feel like as much of unnecessary risk.

Secondly, you should only trade on margin with the brokers you absolutely trust. There aren’t a lot of them, seeing how most of them will happily take your money when you have a good enough stockpile, and then write it off as a ‘malfunction’. Finding a proper broker is a whole other task.

Thirdly, don’t fall for the ludicrous leverages – you’ll do fine with just 1:10 or 1:100. You can take bigger leverages, of course, but only if you know what you’re doing. And even then, it’s not really advisable. It’s better to take a debt closer in size to your own capital, so you could pay it back much easier.

Also, it’s generally better if you don’t risk more than you already do. Bet safely and don’t go for risky big trades that may make you bankrupt as much as make you rich. 

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Carolyn Huntington is an economist, professional trader, and analyst. She made her first big deal in her student years with a profitable investment in Facebook stock. Now the total experience of her trade is 18 years. Over the years of trading, Carolyn has developed its own strategy that allows even those who have never traded on the stock exchange before to earn money. She also creates market forecasts and advises major shareholders, compiles investment portfolios, and teaches how to work with automated advisors.

telephone: 503-547-5192