You may not need to have great knowledge in economy and international trade in order to start your forex trading journey but you will at least know the basic of forex trading before you trade with REAL money. In this article, we will explain on the term “leverage” in forex trading.
Leverage simply means controlling a large amount of money (usually big shares, contracts) with a small amount of money (such as margin), such a practice we use in our daily lives on various financial matters.
Now, let’s follow the KISS theory and keep it super simple so anyone can understand the term and process of leverage.
Let’s say you buy a car on credit and you are in fact leveraging your own balance sheet to buy that car. So, the car’s price is $200,000 but you don’t have the total amount to pay for the car right away, so what do u do? You put 20% down payment that will be $40000 on the car and start paying the bank in consistent turns. The whole point is you are using the small amount i.e. $40000 to control a large amount i.e. $200,000.
Talking about the stock market, the most of the margin accounts will allow you the purchase levered up by factor 2. And now let's look into the method of calculating effective leverage.
The process to find out effective leverage works when you divide the large capital with the small capital so by taking the example described above of purchasing the car we will divide the total value of the car by the car's equity i.e. 5 times leveraged.
($200,000/ $40000 = 5 times) and in stock trading, the leverage will be 2 times i.e. ($100,000/ $50,000 = 2 times) so simply the formula becomes is,
Total Position Size / Account Equity = Effective Leverage
What is the best leverage to use in forex?
We received a lot of questions from our reader on how to use leverage in forex trading? What leverage to use in forex? And the answer is pretty simple – a simple and smart strategy of using low leverage. Please read my explanation below.
Ever wondered why professional forex traders use low leverage? It is because by keeping low leverage your whole capital is protected and when in case you make some trading mistakes you will not be stopped for getting consistent returns. Simply put, if you leverage is low like 20:1 or 50:1 you will lose less and if you leverage high (i.e 200:1 or 400:1) chances are you will lose even more money than your initial capital and no one wants that. So, never use more than 10 times effective leverage.
The reason for such action is actually really simple, let's say your bike can speed up to 150Mph and that doesn't necessarily mean that you always have to keep it at the speed of 150Mph, you can keep moderate lower speed and when in need you can speed it up to 150Mph. High speed can cause accidents and accidents cause life risks same as high leverage can put your forex trading account at high risk.
What does leverage ratio mean in forex?
The leverage ratio amounts are usually like 50:1, 100:1, 200:1 and 400:1. Describing the first one 50:1 will get you the idea of what does leverage ratio mean in forex.
50:1, means you can bet up to $50 dollars on for each $1 dollar in your trading account. For example, if you deposited $500 so according to this ratio you will be able to leverage the amount for the trade up to $25000.
While high leverage may bring you big profit using minimal capital, do take note that you risk is also higher and there is 50% chance that it will go other way too (big loss). We would like advise you to start with low leverage and you are getting better in managing it, you can scale up.