Leverage is a key part of retail trading in forex and it is known as a double-edged sword for a reason. Leverage is a mechanism by which the broker gives the trader the option to increase his buying or selling capacity several times over and above his account balance. The simplest leverage is 1:1 which means that the trader can only buy or sell whatever he has in his account balance. Leverage of 2:1 means that he can buy or sell twice the worth of his account and this goes on with certain brokers offering leverages of even 2000:1.
This enormously increases the capacity of the trader as he can afford to take much bigger trades that are worth several times his account deposit and this allows him to get high returns if the trades go in his favor. But, on the other hand, if the trade goes against him, it would take only a small market move to wipe out his account and this just shows that his money management has gone for a toss and greed has taken over.
What are the Risks and Rewards of Trading Forex on Margin?
One of the main risks of margin trading is the fact that most traders do not know how to trade using it. They tend to over-leverage their trades in the hope of making a quick buck and the market doesn’t move according to the plan and since they have used a lot of margins, it only needs the market to move a small amount for the account to get wiped off. Margin in forex trading should be used only by those who know how to use it. For beginners and for those traders who can’t control their emotions and who do not know proper money and risk management, it is always better to trade with no or very little margin so that they have more control over what they do and even if one of their trades go wrong, it is easy for them to start looking for the next trade and continue to be in the game. It takes a lot of time to master this and so is considered a huge risk.
On the other hand, if you know how and when to use margin, then it can be your greatest friend as it helps you to buy and sell a lot more which also increases the potential profits that you can make from your trade. There have been successful traders who have mastered money and risk management and do know how to make use of the margin given to them so that they take the right trades with the right sizes and make some good profits out of the trades. This is one of the biggest rewards of margin as it can help to quickly make a lot of profits once you know what you are doing.
Why is Leverage Offered in Forex Trading
There are various reasons for trading forex with leverage and the first of those is the fact that, at least on the retail trading systems, you would need to buy a minimum number of units of the currency and for that, the trader would need leverage as even the minimum number of units is very large for a small retail trader. Without leverage, the normal trader would have to deposit a lot of funds to be able to take trades in the FX market, and in most cases, the returns do not justify the amount that has been deposited. The returns are too low for the risk that is taken and for the funds that need to be locked up, from a retail point of view, and hence leverage is given to make it worthwhile and profitable for the traders.
On the other hand, it can also be said that leverage is offered for FX trading to feed the greediness of the traders as they do not find it attractive to trade with no leverage. Without leverage, the profit potential is not very attractive for the traders and so to make it more attractive, the leverage is given to the traders to allow them to make more profits. But the fact is that using high leverage only leads to more losses most of the time and it does not serve the purpose at all. But retail traders, most of the time, do not realize this problem and continue to trade with the high leverage that is offered to them.
What is a Margin Call?
When you start trading and if you choose to trade with margin, then you must know what a margin call is as it would wake you up to the risks that are associated with trading with margin. A margin call is basically closing out of all your open trades as your account does not have sufficient equity or balance to sustain the trades any longer. This basically means that your account is wiped out and so once all the open trading positions are closed, there will be nothing left in your account.
The reason why is it called a margin call is that as the trades that are open move in the opposite direction and you start accumulating losses, your equity would start going down and you would need to add additional funds or margin to keep the positions open. If you are not able to do that, then it means that you don’t have enough margin to sustain the positions and the broker would need to close all your trades for lack of margin and also to ensure that he does not lose more than what is available in your account.
That is why you need to be careful when you have a leveraged trading position open. It basically means that you are trading on borrowed money and under normal circumstances, your account does not have enough funds to sustain such a position. Since the position is bigger than what you can afford, the risk is also bigger and so you need to be careful with your money management. You need to ensure that you have the right stop losses so that you are sure when your trade is going to go wrong. This will also help you to save your account from margin calls and would still allow you to make more trades and stay in the game for longer and this would help you to understand FX trading even more. So, make sure that you know what you are doing when taking leveraged FX positions and keep a close watch on them if you can. Or better, avoid FX positions that are more leveraged than what you can afford to have.
So, as said many times before, leveraged trading in forex is a risky business for those who do not know how to make optimum use of it. While the reasons that the broker might offer you this facility might be many, for you it does present a risk and an opportunity and you should start your trading career with the lowest leverage possible. This will give you a shot to make many more trades in your account before it blows up and every trade is a learning experience for anyone new to FX trading.
This might be boring at the start as you may not be making as many profits as you would like to but you need to understand that trading is a marathon and not a sprint. Whatever you can do to keep yourselves in the game for a longer time would be useful for your trading career and so the ultimate aim is to develop a proper money and risk management strategy so that you can stay in the game for as long as you possibly can. Once you have managed to achieve this, then it is easy for you to scale up your positions and begin to use margin and leverage to your advantage, and quickly make up for the lost time. But unless you have the patience to do what you have to do at the start of your trading career, you may never end up learning the right things which will only put your trading career in jeopardy. The sooner you learn to make use of leverage, the better it would be for the trader in the long run.