What is Leverage?
Leverage is the ability to make large trades in the market with only a small amount of actual capital in your account. Forex brokers offer leverage as a way to make the market accessible to the average investor. Most traders donÃ¢ÂÂt have 10k to get started with forex trading. If a forex brokerage provided a trader with leverage of $200 to every $1 deposited(200:1 leverage), it would only take a deposit of $50 to open and control a 10k trade.
How Can Leverage Hurt You?
Leverage can be a sharp double edged sword. It can work for you, or against you. If you make a trade with a mini trading lot of 10k, each pip would be worth around $1. If you gain 5 pips, everything is great, you used $50 and made a 10% return. If you lose 5 pips, you have a 10% loss just as fast.
While it is really nice to think about the money you can make, the money that can be lost is rarely discussed . Leverage can be very dangerous if used improperly. Brokers can offer heavy leverage, but that doesnÃ¢ÂÂt mean that you are forced to use it all the time.
Using Extreme Leverage
While looking for a broker you will discover that there are brokers out there that offer extreme leverage. Some brokers will even offer you 400:1 leverage. This would allow you to open an account with $300, and use that same amount to control up to 120k worth of trades. The average pip size with a trade of 120k is $12.00. If your trade lost 25 pips, your entire account would be wiped out. Considering that most currency pairs can move 25 pips in less than 10 seconds, that sounds pretty dangerous doesnÃ¢ÂÂt it?
Using Leverage as a Tool
The dangers of using too much leverage are rarely talked about, but are pretty obvious if you think about it. This doesnÃ¢ÂÂt mean that you have to use the full amount of leverage just because itÃ¢ÂÂs there. In fact, there are ways to use leverage in useful ways that will give you an advantage.
A good time to use leverage is when adding to a winning trade. If you have a trade that has progressed favorably and you want to add to it, this is a good use of leverage. This is called leveraging your profits.
Overall the best use of leverage is when position trading. ItÃ¢ÂÂs tempting to use extreme leverage to make a fast profit on single trades, but the risks are just not worth it.