Forex leverage simply refers to a trader’s ability to increases the size of his/her trade by using credit from a brokerage firm. When trading forex using leverage, a forex trader is automatically borrowing money from a forex broker and at the same time, using the funds in his trading account as collateral. The borrowed funds can be used as a funding source when trading instruments in the forex market and also have the capacity to generate profits on risk capitals. Leverage provides traders with the opportunity to pay less than the usual full price for an instrument’s trade, giving them the ability to enter bigger trade positions that would have not been possible with their account funds alone.
UNDERSTANDING LEVERAGE AND MARGIN
Margin trading is the ability of a forex trader, owing a margin account to borrow money from his/her broker. The borrowed fund is seen as a loan which is payable with interest. This borrowed fund amplifies the possibility of buying more financial assets that would have not been possible at the start. There is a huge correlation between leverage and margin. Every forex trader uses margin to create leverage. Leverage is seen as the increased purchasing power that is offered to margin account holders.
For example, for a trader to trade 50,000 dollars of currency, with a margin of one percent (1 %), the only requirement is to make a deposit of 500 dollars into his/her margin account. The leverage ratio provided by the broker on a trade like this is 50:1.
FOREX LEVERAGE FOR BEGINNERS
Leverage trading is a very important tool for forex trading beginners. A leverage gives newbies the possibility to control a huge amount of money while owning a relatively small amount. This feature provides them with the advantage of taking hold of every possible trading opportunity that presents in their way. This leverage gives traders the ability to make profits from the high fluctuation nature of the forex market. Leverages also provide the ability trade forex on a shorter timeframe. For example, when using a 1:30 leverage ratio. This means that for every one dollar that is deposited in a trading account, the forex trader has the authority to purchase currencies worth 30 dollars.
REASONS WHY FOREX LEVERAGE IS BETTER FOR LONG-TERM SUCCESS
There is a greater probability of profit maximization when trading forex with leverages. Trading with a leverage has no restriction to the type of financial asset being traded. Leverages give forex traders the ability to increase return in every trade venture just by using a small initial capital. Since the major benefit of leverages are capital increments, investors and traders can triple their start amounts and take advantage of every trade opportunity they encounter. Borrowed funds are seen as money boosters in the forex market.
UPSURGES CAPITAL EFFICIENCY
There is a greater increase in capital efficiency when using leverages. For example, if it required two months for a trader or an investor to generate profit from his/her funds, it will take less than one week for the same trader to make more profits from leverages thereby increasing capital efficiency. This means that the funds/capital/money of a forex trader can be turned in again and again in future transactions generating more capital. So, aside from the fact that leverages produce a reasonable amount of income, they also increase returns in a limited amount of time.
REMEDY AGAINST LOW VOLATILITY
Long-term forex traders who trade financial instruments in the forex market use leverage as a hedge against low volatility. Trades that experience volatility are instruments that generate a high rate of returns when compared to other moving securities. Leverages have the ability to stop low volatility by producing profits from small transaction size. Using leverages on trade positions, forex traders can ignore market price fluctuations while placing importance on small price movements.
ESMA RULES AND ITS INFLUENCE ON FOREX LEVERAGES
ESMA (European Securities and Markets Authorities) have recently developed the underlying rule on the following leverages:
- A 30:1 leverage on all major currency pairs with a margin of 3.30%
- 20:1 leverage ratio on major indices with a margin of 5%.
- 10:1 leverage ratio on commodities with a margin of 5% (excluding gold).
- 5:1 leverage on equities with a margin of 20%
These rules have heavenly increased the margin required to trade various financial instruments. These rules may result to a scenario where forex traders will engage in trading with offshore brokers who are far from being regulated and not subject to the regulations on leverages.
In conclusion, although leverages can be used by forex traders to generate profits from the fluctuations in exchange rates that take place in the forex market, using high leverage trading can be detrimental by magnifying losses. Highly leveraged trading only signifies that the financial asset has more debt than equity.