You’ve got a few hundred pounds to start trading in forex, but this isn’t enough – or so you’ve been told. You keep hearing about people trading with £10,000 or more. How do they do it? Answer: leverage. Leverage is very common in forex and, while it doesn’t sound like a good idea, it’s one of the best ways to build up a bankroll. Here’s what you need to know about this amazing financial strategy.
What Is Leverage?
Think of leverage as a loan. You’re borrowing money from a broker in order to trade in a financial market. In forex, you’re borrowing money to trade in the currency market. This money is not yours, and normally you would pay interest on borrowed funds, but you don’t in the forex market unless your position does not close out before the delivery date. If this happens, your loan will be rolled over and you may be charged interest depending on your position.
In the U.S., Americans are limited to a 50:1 leverage. This means for every $1 they invest, they can only trade with up to $50. In the UK, of course, the limitations aren’t as bad, so you may find yourself trading £100 to £400 for every £1 invested.
So, let’s say you’re trading on something like the Metatrader platform and you want to do high margin trading. You would set up your account, and deposit your funds. Of course, you would already have filled out an application for the account and taken care of the small details. When you deposit money into your account, you would be ready to trade at multiples of your own investment. You would never be required to trade with all of your capital, but you will need to obey the margin rules of the broker.
What Are Margin Calls?
A trader’s worst nightmare is a margin call. This is when your loan comes due, and sometimes it happens at inopportune times. The broker wants his money back and he wants it immediately. Your positions can be force-liquidated, and you could be pushed out of the marketplace.
If this happens, you may end up owing the broker money – especially if you’ve gone into the red. Some trading strategies require you to wait things out, so this can be especially stressful, since you may be about to make a profit in your trade when the margin is called due.
However, it’s rare for a broker to arbitrarily call your loan due. Usually, this only happens when your drawdown is significant and the broker is concerned that you won’t be able to repay the debt.
Brokers set a minimum maintenance margin, and if your account falls below this amount, your broker will automatically call the loan. You may be given the opportunity to add more funds, but many brokers simply flatten your account to minimise your (and their) losses.
Use Of Leverage
Traditionally, the use of leverage was antithetical to sound principles of money management. It’s one of the riskiest positions you can take. But, many traders compensate for this by using a combination of stops and a large bankroll.
Usually, leverage is kept low for new traders, and you should never risk more than 1 to 2 percent of your total savings on any one trade.
This helps you control losses, which is at least as important as seeing gain. Many traders use automated trading schemes to take emotion out of the trading equation too, though this does not necessarily guarantee success.
Tips For Using Leverage
If you’re going to use leverage, cap your losses. If you want to profit big, you first have to understand how to minimise losses. Start with something like a 5 pip stop. This means when the market moves against you 5 pips, you’re going to exit your position. It’s a weak loss, but it will get you some practice and it will also teach you just how quickly the market can move sometimes.
Many traders use 20 pips as a general starting point.
Use strategic losses – this is another way to cap losses. Sometimes you want to not just stop your account from going red, but from losing profits you’ve made. Many times, you’ll enter a trade at night, go to bed, and wake up in the morning to find the market has moved significantly. Strategic stops can protect profits you’ve earned early on in the trade, and prevent you from having to start all over the next day.
Don’t get emotional about your trades. This is a common mistake made by new traders. Revenge on the market never works. Likewise, don’t stick to losing trades when there’s no rational reason to. When the trend is clearly gone, it’s time to pack it up. When the range is clearly not working for you, then you need to pull out of your position.
Finally, don’t get crazy with leverage. Even if you’re allowed 100:1, you don’t have to use it. Start with 25:1 or even 10:1 to get the hang of it. If you lose, you won’t lose a lot.
Logan Francis is a self-confessed Forex fanatic who is constantly learning as much as he can about it. When he finds out something new and helpful, he likes to share it with other readers on the web.