Forex trading is one of the most attractive forms of financial trading for the retail investor simply because the minimum deposit most brokers require is extremely small, but profit levels can be quite high. This is because the foreign currency exchange market offers some of the highest leverage levels of any financial trading market.
What Is Forex Leverage?
Leverage, or trading on margin, simply means that the broker lends the trader a certain amount of money to purchase contracts or securities, or currency units in the case of Forex trading. Brokers dealing in the foreign currency exchange market offer some of the highest levels of leverage, with some going so far as to offer 500:1. However, the majority of brokers tend to offer 100:1.
This ratio means that for every $1 the trader deposits, the broker is willing to lend them $100. Thus, the trader can make the same level of profit as if they had an open position of $100 instead of just the $1 they funded their account with.
The Pros and Cons of Leverage
The clear benefit of forex leveraging is that a retail trader with a small deposit can make a much larger return from their trading than if they could only use the money the deposited. In fact, the profits are virtually unlimited for experienced and knowledgeable traders.
However, while the profits can be unlimited, the risk of loss is also significant. Yes, there is only so much you can lose until you hit margin closeout, which essentially means that your trade is closed automatically once you have lost a certain amount of your deposit. The latter can be just under half the amount of your total account balance but this can vary from broker to broker.
While this might not seem like much of a problem if you have only invested $100, things can get a little less pleasant for those that have large deposits. Thus, a $10,000 account can drop to below $5,000 or even less, in a few minutes, thanks to the volatility of the Forex market.
This is why it is important for anyone engaging in Forex trading to mitigate their risks as much as possible. This can be achieved by limiting the amount of leverage you agree to, since you have a choice, as well as not using all your available funds. By allowing yourself a drawdown buffer, you have more room to move if the market changes direction temporarily.
Why Do Brokers Offer Leverage?
You might be wondering why brokers are willing to offer leverage. After all, aren’t they risking their own funds? Actually, no, they aren’t risking anything. This is because, whether you profit or incur losses, the broker still makes money on every transaction, which means they wish to encourage people to trade. The more profit people have the potential to make with Forex trading, thanks to leveraging at high ratios, the more likely they are to trade and the more money the broker will make.
The high leverage offered by forex brokers is one of the main attractions of Forex trading when it comes to retail investors. However, it is wise to remember that it could lead to quick and hefty losses if a trader isn’t cautious, just as it can lead to significant gains. Thus, caution is advised when choosing the amount of leverage you choose to use for your Forex trading activities.