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What is leverage and how to properly choose it

Table Of Contents

  1. Crediting scheme
  2. What the leverage is needed for
  3. Evolution of brokerage services
  4. Leverage threats
  5. How allowable losses can be calculated
  6. Real leverage size
  7. How to choose trade conditions offered by DC
  8. Summary

Starting working with Forex most traders have to absorb terminology of financial markets and to study basic principles of their functioning. One of these key principles is Forex leverage. Understanding of its essence and principles of its usage is very important.

Crediting scheme

The core of this operation is that broker actually gives his own money in the form of the loan to each trader. This money helps buy and sell much more currency volumes than only own capital does.

However, here a question is raised why trader needs any loans. Why can he not trade only with his own money without using the borrowed funds? This moment is always disturbing for the newcomers. However, there is nothing to worry about as the broker doesn’t risk so much as to further raise claims against the beginning currency profiteer.

What the leverage is needed for

After the trade transaction is fulfilled trader can get profit or lose his money for each price change point. Each point (or pip) is a change of currency quotation for its 0.0001 part. Of course, it is a very small change so to earn money under such conditions one should operate with big amounts.

While making the transaction with the standard Forex lot trader buys or sells 100 000 currency units. That is why one-pip price fluctuation for main currency pairs is 100 000 multiplied by 0.0001 that is 10 currency units of profit or loss. Most traders especially the beginners do not have such a big amount of 100 000 to enter trading and buy one lot. Until recently it has been the biggest obstacle that didn’t allow most people starting making money on currency quotation changes.

Evolution of brokerage services

In the course of time the situation has been changed and brokerage companies have created ideal trading conditions for everyone. That is why one should have a clear understanding what the Forex leverage is. Let see the process on the example. If the leverage is 1:100 the trader can work with standard Forex lot of 100 000 USD having only 1000 USD on his account. The remaining 99 000 USD are lent by the broker. Using this method the trader will gain or lose his 10 USD in any case however he needs just 1000 USD as a startup capital.

After position is closed profit or loss will be deposited to the account and borrowed money will be given back to broker. Possible loss is taken only from the trader’s account. In case if the possible

losses can exceed trader’s deposit the broker can close the position and take his money back. Thus, by operating with large amounts of money trader is always responsible only to the limit of his deposit and cannot be indebted to the broker.

Leverage threats

So now every trader knows that Forex leverage can help get significant profit even at the smallest fluctuations of one pip. On the other hand usage of the leverage can also cause significant losses. The major threat for the beginner is that he ignores the necessity to calculate allowable risks.

Usage of big leverage can quickly reduce the capital to zero after one or two trade transactions without proper capital management.

Big losses will not destroy the deposit if the usage of leverage is combined with capital management. As the usage of Forex leverage assumes risk that does not exceed 2% of the total account even the series of unsuccessful transactions will not be able to drain trader’s deposit.

How allowable losses can be calculated

What is 2% risk and how should one calculate it for the given trading conditions? Let’s look at the example. The trader has 20 000 USD and he opens a transaction with insurance stop loss of 30 pips. Maximal risk of the given trading operation is 400 USD as 2% of 20000 USD is 400 USD.

As one pip of standard lot is 10 USD we can see that allowable 30 pips of the loss give the exact number of the possible loss – 300 USD. It means that the loss is less than maximal allowable loss of 400 USD so one can easily open the trade order.

Real leverage size

Knowing the definition of the leverage in Forex it is very easy to calculate it for any trading conditions. The total amount of the open trade transaction is to be divided by the deposit amount. For example, trader buys common lot of 100 000 USD. At the same time he has equal amount of money on his account. So, in this case correlation between the lot and deposit amounts is 1:1 that is the trader does not need additional credit funds. If the trader has only 10 000 USD real Forex leverage is 100000: 10000 = 10:1.

How to choose trade conditions offered by DC

While choosing a broker trader should pay attention to the possible levels of leverage and its maximal size that accounts for the size if credit DC can offer to its clients. So, if you see the company with 500:1 or 100:1 leverage you can understand what it can do on Forex with such level of leverage.

This moment can be crucial under certain trading conditions or applied strategy. For example, small deposit and intraday trading presupposes working with big leverage by default as potential profit will not cover possible losses and trading on Forex will appear to be irrational.

This knowledge will help define the proper leverage in Forex the beginner can choose. As a rule, newcomers are strongly recommended to avoid using big leverage at the very beginning. They should use leverages with correlations not exceeding 100:1.

Summary

So, trader knows what the Forex leverage is and what possibilities it can give for trading with money of the dealing center and placing positions with big volumes. However one should always take into account that the leverage can increase not only your profit, but also your possible losses. Moreover, one should also keep in mind elementary rules of the risk management as big leverage and trading volume chosen with complete unconcern can easily empty out trader’s deposit.