Market Analysis

Understanding how to trade foreign currencies necessitates a thorough understanding of the economy and political circumstances of individual nations, global macroeconomics, and the impact of volatility on certain markets. 

However, first-time forex traders are rarely confused by economics or global finance. Instead, a simple lack of knowledge about how to handle leverage is frequently the source of trading losses.

Data released by the main foreign exchange brokerages as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act show that the vast majority of retail forex consumers lose money. The overuse of leverage is frequently cited as the cause of these losses.

This article describes the risks of excessive leverage in the forex market, outlines techniques to mitigate harmful leverage levels, and teaches readers how to choose the appropriate degree of exposure for their comfort.

The Risks of High Leverage

Leverage is the method by which an investor borrows money to invest in or buy something. In forex trading, capital is usually obtained from a broker. While forex traders might borrow large sums of money based on initial margin requirements, they can profit considerably more from successful transactions.

Historically, many brokers could offer leverage rates of up to 400:1. This means that with a $250 deposit, a trader can control about $100,000 in currencies on the worldwide FX markets. However, in 2010, financial rules reduced the leverage ratio that brokers could offer to US-based traders to 50:1 (which is still a significant amount). This means that for the same $250 deposit, dealers can control $12,500 in currencies.

So, should a beginner currency trader use a low leverage ratio, such as 5:1, or risk it all and go up to 50:1? Before responding, it is crucial to look at examples of how much money may be won or lost with different levels of leverage.

Example Using Maximum Leverage

Assume Trader A has a $10,000 cash balance. They decide to utilize 50:1 leverage, which allows them to trade up to $500,000. In the realm of currency, this is equivalent to five ordinary lots. Forex deal sizes are classified into three types: normal lots (100,000 units of quote currency), mini lots (10,000 units of base currency), and micro lots (1,000 units of quote currency). Movements are measured in pips. Each one-pip movement in a typical lot results in a 10-unit change.

Assuming the trader bought five standard lots with the US dollar as the quote currency, each one-pip fluctuation would cost $50. If the trade goes against the investor by 50 pips, the investor will lose 50 pips multiplied by $50, or $2,500. This represents 25% of the total $10,000 trading account.

Example Using Less Leverage

Let's consider Trader B, who opts for a more conservative leverage ratio of 5:1, compared to Trader A's 50:1. With a $10,000 cash balance, Trader B can trade up to $50,000 worth of currency. Each mini-lot, costing $10,000, translates to a $1 change per pip. Given Trader B's 5 mini lots, each pip movement results in a $5 change.

In the event of a decline by 50 pips, Trader B would incur a loss of 50 pips x $5 = $250. This loss represents just 2.5% of the total position.

How to Pick the Right Leverage Level

Investors should evaluate widely acknowledged standards before deciding on a leverage level. The simple three rules of leverage are as follows:

Maintain a low degree of leverage.

Use trailing stops to limit the downside and protect capital.

Limit capital to 1% to 2% of total trading capital for each position held.

Forex traders should select the level of leverage that feels most comfortable. If you are conservative and do not like taking large risks, or if you are still learning how to trade currencies, a smaller degree of leverage, such as 5:1 or 10:1, may be more suited.

Trailing or limit stops allow investors to lower their losses when a trade goes awry. Using limit stops allows investors to continue learning how to trade currencies while limiting potential losses if a trade fails. These stops are particularly significant since they serve to eliminate trading emotion and allow people to step away from their trading desks without emotion.

Conclusion

The appropriate forex leverage amount is determined by a trader's experience, risk tolerance, and comfort in the global currency markets. New traders should become acquainted with the terminology and exercise caution as they learn how to trade and gain expertise. Using trailing stops, keeping positions modest, and limiting the amount of cash allocated to each position are all smart places to start when learning how to handle leverage properly.

Disclaimer

Derivative investments involve significant risks that may result in the loss of your invested capital. You are advised to carefully read and study the legality of the company, products, and trading rules before deciding to invest your money. Be responsible and accountable in your trading.

RISK WARNING IN TRADING

Transactions via margin involve leverage mechanisms, have high risks, and may not be suitable for all investors. THERE IS NO GUARANTEE OF PROFIT on your investment, so be cautious of those who promise profits in trading. It's recommended not to use funds if you're not ready to incur losses. Before deciding to trade, make sure you understand the risks involved and also consider your experience.