Forex trading has millions of adherents worldwide. Every day, vast sums of money change hands as individuals, institutions, and governments take part in buying and selling of currency pairs. Each transaction includes two currencies, with the trader taking a position on which one of the two will rise in relative value. However, individuals who have limited capital in their accounts often turn to leverage in order to magnify their buying power. If you have never used the technique or want to learn more about it, it’s critical to know the basics, understand how ratios work, review the various ways to safeguard your capital and learn the common risks associated with leveraged trading.
Basics
The two most significant things to know about leveraged buying are how to get started with the technique and how to employ risk management tools to protect against large losses on every position you take. Brokers typically offer much higher trading account leverage to forex clients than to futures or equities traders. That’s because currency prices don’t fluctuate nearly as much as stocks or futures. There are two components to the concept. The first is margin requirement, and the second is ratios. When your broker imposes a five percent margin requirement, for example, that means you must have at least five percent of the trade amount in your account. If you wanted to buy a currency pair for £5,000 with a five percent margin, your account collateral would have to be at least £250.
What About Ratios?
Ratios are tied to margin requirements, both mathematically and conceptually. Suppose your account requires a five percent margin, as in the example above. What is the leverage ratio? It’s 20-to-1, and the way you figure it out is simple math. Divide one hundred by the margin percentage, or in this case, 100/5, which is 20. That means you control 20 times your actual purchase amount when you operate under those circumstances.
Risks Are Real
The obvious risks of using leveraged trading are rather obvious. When you make a good decision, for instance, and the currency you purchased rises in value, your gains could be considerable. But if the price goes against you, then your loss is magnified by the same factor. The potential gains and losses depend on the ratio. The higher it is, like 100-to-1 or 200-to-1, then the riskier the trade. The risks of forex transactions are real, just as in any other field. However, because brokers allow more leverage for forex accounts, you stand to face a double-edged sword with gains and losses.
Use Safeguard Tactics
Is there a way to protect your capital when using an outsized magnification of buying power? The safest route is to place very precise stop-loss points on every transaction. So, if a trade moves against you, the broker will automatically liquidate the position at the specified point below the entry. Some forex brokers such as easyMarkets offer free, guaranteed stop loss, which provides extra peace of mind when trading. Keep in mind that many investors also employ upside stops, also called take profit, to lock in potential gains. The point is to bank a positive result before the currency’s price experiences a reversal and potentially erases the initial gains.
