Leverage literarily means to assist. This is one of the main attractions of forex and makes it better in comparison to the stock market. Forex leverage is the ability to control a large amount of money in the forex markets, with a much smaller deposit. For instance, if a forex brokerage offers 500:1 leverage, that means for every $1 that is in your account, you can trade $500 on the forex market. So it translates to doing more business more than your investment.
Forex brokers offer leverage which gives opportunity to make more money with your (little) investment if properly used. For example, let’s say that you have $1000 in a trading account. If you were to put a $1000 trade on the market, the approximate pip value would be 10 cents. If you trade moved in a favourable direction for 10 pips, your profit would be $1.00, or 0.1 per cent. If you were to use 10:1 leverage and make that same trade, you still would only have to have $1000 in your account, but your trade value would be $10,000. On a $10,000 trade, the approximate pip value would be $1 per pip, so a 10 pip move would result in a profit of $10 or a 1 per cent gain.
Leverage amounts or sizes
Leverage is usually given in a fixed amount that can vary with different brokers. Each broker gives out leverage based on their own rules and regulations. The amounts are typically 1:50, 1:100,1: 200:1, 400:1, 1:500. The lowest of the leverage aforelisted is 1:50 while the highest is 1:500. The lower the leverage, the lower the risk; and the higher the leverage, the higher the risk.
One hundred to one leverage means that for every $1 you have in your account, you can place a trade worth $100. This is a typical amount of leverage offered on a standard lot account. The typical $2000 minimum deposit for a standard account would give you the ability to control $200,000.
Two hundred to one leverage means that for every $1 you have in your account, you can place a trade worth $200. This is a typical amount of leverage offered on a mini lot account. The typical minimum deposit on such an account is around $300. With $300 you would be able to open up trades up to the amount of $60,000.
Leverage and margin
Leverage also determines the margin required to place an order successfully in Forex. A lower leverage will require a lower margin while a higher leverage will require a higher margin. For example if you are to buy or sell 10,000 units of say GBP/USD pair at an exchange rate of 1.5000. This means you want to buy 10,000 unit of the base currency. That translates to having $15,000. But using a leverage of say 1:500, you will only require to ‘drop’a margin of $30 to pull the trade through.
Leverage and risk/reward management
Leverage has been explained as giving more power with small investment to control a large amount hence more purchasing power. With a higher leverage of 1:500, you can place more trade orders five times than a lower leverage of 1:100 hence more profits can be made. Likewise the more exposed you are to losses as well. A trader’s style and risk aversion or appetite will determine his leverage size. In a case of total closure of account due to losses a trader with leverage 1:100 will have a residual balance five times more than a trader using a leverage 1:500
Leverage is always chosen during opening of live accounts. But it can be changed later if the trader finds it not suitable but on the condition that all open trades must be closed. Also some brokers do change leverage without notice to a lower one to penalise for scalping.
Professional traders and leverage
For the most part, professional traders trade with very low leverage. Keeping your leverage lower protects your capital when you make trading mistakes and keeps your returns more consistent. Many professionals will use leverage amounts like 50:1 or 100:1. It’s possible to trade with that type of leverage regardless of what the broker offers you. You just have to deposit more money and make fewer trades. Also professional traders can still take advantage of very high leverage with very few trades and possibly a few more when opportunities arise rather being constrained as in the case of very low leverage.
In general, the less leverage you use the better. It takes experience to really know when to use leverage and when not to. Staying cautious will keep you in the trade for the long run.