One of the peculiarities of the Forex market is the possibility of using what we call leverage.
The principle of Forex leverage:
Online brokers who allow investing in the exchange market offer their clients to benefit from leverage. This tool makes it possible to speculate on more money than the capital available, in order to make profits more attractive (but also to increase the risk of losses).
There are several levels of leverage that generally range from 1: 100 to 1: 400. A leverage of 1:100 means that you multiply your investment on a currency pair by 100. But then where does this money come from? It is simply the agent himself who lends you this money for free
Why leverage is indispensable for Forex speculation:
To understand the value of using leverage when trading on the Forex market, it is necessary to understand that changes in the prices of currency pairs are often very low compared to other assets such as equities. Without leverage, it would be very difficult to make a profit, even if you have consistent investment capital.
Advantages and disadvantages of the leverage effect
As we have just seen, the leverage effect has some advantages. The main one is that it allows you to make more interesting profits in a short time, especially if you trade stocks with CFDs.
However, the leverage effect also presents a risk that should not be ignored. Indeed, while your profits can be multiplied by the leverage ratio chosen, your losses can also be multiplied. Thus, a position with a leverage effect of 100 that loses one euro will actually lose you 100 euros. It is, therefore, necessary to have sufficient capital in the trading account to cover these possible losses and know how to stop them at the right time.
Using a leverage effect is still a very advantageous method but requires good management to limit risks and not to lose all your capital because of a bad strategy. As far as stocks are concerned, we advise you to use only weak leverage effects, at least as long as you do not fully dominate the market.
Example of Leverage:
Suppose you invest 100€ of purchase on the EUR/USD cross for 1.25 pips. At the time of the closing of its position, the EUR/USD cross has reached 1.26 pips. Without leverage, your profit can be calculated as follows:
100 x (1.26 – 1.25) =1
I would only gain one euro on this transaction.
Let’s now assume the same trade with a leverage of 1:100. In that case, your real investment is €100, you will speculate on €10,000. Your profit will then be calculated as follows:
10 000 x (1.26 – 1.25) = 100
This way, you will win 100€ and not 1€.
Of course, the more important the leverage, the more important the potential gains. But this advantage is double-edged since the amount of your losses will also be multiplied by this same factor.
How to behave when faced with the risk of forex leverage:
As we have just indicated, leverage should be used wisely and prudently, as your losses are also affected by this tool. So, with a leverage of 1:100, the amount of your losses will also be multiplied by 100.
If we look at our previous example and assume that our EUR/USD cross from 1.25 to 1.24 pips, you would then lose €1 without leverage and €100 with leverage. The more important leverage is, the more you risk losing money, so it is advisable to use minimum leverage to reduce risk.
The precautions to take when trading with leverage
y using leverage, you multiply your investment and therefore your potential return by a significant amount. However, this leverage must be used wisely, with a few precautions to avoid losing too much money.
For example, if you lose 60 pips in your order batch and your margin account does not have sufficient funds to cover this potential loss, the broker makes a margin call notifying you that you must reconstitute your coverage by adding the necessary funds to your account. Otherwise, you close your position and you then lose 50% of your initial capital. It is therefore essential to manage your strategy well, taking this leverage into account, for example by using several orders simultaneously (if-done or OCO orders).
Therefore, leverage should be handled with caution as it allows you to make significant gains, it can also put you at great risk. For example, it is advisable to start trading using small leverage effects in order to test the market. Then all that remains for you to do is to increase this leverage if you see that the market is developing in your favour.