Lesson 16 – Leverage for Forex Traders
At this point in the course you’re probably wondering how people seem to make a significant amount of income from trading forex when the values for each pip is so small, especially if you’re managing risk properly.
You might think that you need a huge amount of trading capital to make even a decent amount of trading income. This is not the case. This is where leverage comes into play.
Leverage gives you the ability to make trades with sizes that are much higher than your account balance amount by using your balance as margin.
This leverage is written as a ratio of the amount you can trade with vs the amount of money you have in your account.
Example: If you have £1,000 in your account, and your brokerage allows you to leverage 20:1, then your possible trading balance can extend to £20,000
Let’s use the property market as an example to show how leverage can benefit us and our ability to succeed as a trader in making profits.
Leverage example in real life
Let’s say you have £50,000 and you want to buy a house that’s more expensive than what your current account balance allows.
So let’s say this house that you’re looking at is priced at £250,000, so you’ll go to a bank to ask if you can get a mortgage for it.
The bank will give you that mortgage under the condition that you make a down payment of 20% of the house value.
This means that you are paying £50,000 upfront while the bank gives you a loan of £250,000.
If we look at this example in a leverage ratio lens, the ratio is 5:1.
Now let’s say after 4 years, the house increased in value to £500,000. This is an increase of 100%.
Now let’s compare what would have happened in this scenario if we bought a house with only our own budget of money, versus using leverage like we just did.
So, let’s say we used our £50,000 to buy an apartment with only our own budget of £50,000 and this also increases by 100%.
Here, we have the same percentage increase in value, but how do the profits differ between the leverage and non-leverage method?
TABLE SHOWING THE TWO SCENARIO DIFFERENCE ACROSS LINE ITEMS OF %INCREASE, NEW VALUE OF PROPERTY, PROFIT, AND LEVERAGE USED
As you can see above, using the power of leverage, we made an additional £200,000 profit than how we would have if we didn’t use leverage at all.
The same idea applies to leverage in the forex market.
But of course, there are also downsides to using leverage in forex trading.
So let’s have an overview of both the pros and cons of using leverage.
Pros of leverage
- Because of the higher exposure to the market, you can make a larger rate of profit on your winning trades.
- Leverage can be considered as a short-term, interest-free loan.
- Margin requirements are low
Cons of leverage
- Because of your higher exposure to the market, not only can you make higher profits, but you are also at risk of making higher losses.
- If you trade at high leverage ratios, you can experience what is called a margin call. This happens when your margin account balance drops below the minimum required amount. This means the broker has the right to liquidate (empty) your portfolio and any trades you’re currently in. This basically means your account will be looted and you’ll be left with nothing. So be very careful about this.
Margin calls are easily avoidable as long as your risk is managed effectively and you use stop losses to protect yourself from big losses that would otherwise drive your account below the required minimum.
It’s important to understand that leverage doesn’t lead automatically to great profits, it just enlarges the size of your trades and exposure to the market, and the same goes for the resulting profits/losses.
This is the end of this lesson and also chapter 2 where we covered understanding the market. Next, for Chapter 3, we will cover “Technical Analysis Basics” that you need to know for successful forex trading. See you in the next chapter!