Why Leverage Is Important for Forex Traders?
Put simply, leverage involves borrowing a certain amount of money from your broker in order to magnify your trading profit. In order words, leverage could be summed up in four words: "Doing more with less".
Leverage is very essential for a retail trader if he/she wants to make money from Forex trading. The reason is that the average volatility – percentage-wise – of a major currency is less than 1%, meanwhile, a stock can easily have a 10% price move on any given day.
This means that you need more capital, in order to benefit from the fluctuations of the currencies. Because few retail traders are able to provide $100.000 to trade one standard lot, FX brokers provide retail traders with leverage that does not require them to lay out the entire sum.
As such, if a brokerage effectively provides a retail trader with leverage of 100:1, all he/she needs to do is pay $1,000 as “initial margin”, the deposit needed to trade one standard lot. What then does then term “margin” mean? Below is a more detailed description of it.
What is Margin?
Margin can be defined as the amount of money or collateral deposited by a customer with a broker. In other words, it is a "good faith deposit" needed by your Forex broker to cover the position you have opened into the market.
The margin, in combination with leverage, will be used by Forex4you to open and maintain your positions, and to cover any potential losses.
There are also risks involved when trading with leverage and margin, consider the following:
Forex brokers provide leverage is as it allows retail traders to control a larger amount of funds.
While leverage does not affect the value of a lot, it does allow you to trade more.
The higher the leverage employed, the less margin required to control one standard lot.
How Can Leverage Backfire?
While traders are able to earn significant profits by using leverage, it can also work against them. How? If the currency underlying one of your trades moves in the opposite direction of what you expected would happen, leverage will greatly magnify the potential losses.
To keep such catastrophe at bay, Forex traders usually implement a strict trading strategy that includes the use of stop orders as well as limit orders as they are designed to control potential losses. We will discuss these topics in the upcoming lessons.