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What is leverage and how is it used in forex trading

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Forex trading has grown, because of the increase of online trading platforms

 

Leverage is in fact funds on loan.

 

Some safety measures used by professional traders may help minimize the risks of leveraged forex trading:

 
Leverage is in fact funds on loan. Leverage is used for physical assets such as real estate, and for financial assets such as forex. Forex trading has grown, because of the increase of online trading platforms and the accessibility of cheap credit. The use of leverage magnifies gains and losses.

If you are based in the U.S. and have an account with an online forex broker and your broker provides you the maximum leverage permissible in the U.S. on major currency pairs of 50:1, which means that for every dollar you put up, you can trade $50 of a major currency. You put up $5,000 as margin, which is the collateral or equity in your trading account. This implies that you can put on a maximum of $250,000 ($5,000 x 50) in currency trading positions initially. This amount will obviously fluctuate depending on the profits or losses that you generate from trading. (To keep things simple, we ignore commissions, interest and other charges in these examples.)


If we assume you started with the above trade with exchange rate EUR 1 = USD 1.3600 (EUR/USD = 1.36) and wait for its decline in the near term. Your leverage in this trade is just over 27:1 (USD 136,000 / USD 5,000 = 27.2, to be exact).

Since the euro is quoted to four places after the decimal, each “pip” or basis point move in the euro is equal to 1 / 100th of 1% or 0.01% of the amount traded of the base currency. The value of each pip is expressed in USD, since this is the counter currency or quote currency. In a trade of EUR 100,000, each pip is worth USD 10.

To stop losses you set a stop-loss of 50 pips so the loss is USD 500. If the euro falls to a level of EUR 1 = USD 1.3400 after you started the trade you close out the position for a profit of 200 pips (1.3600 – 1.3400), which is USD 2000.

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If you sold EUR 100,000 and received USD 136,000 in your opening trade, when closing the trade, all you did is bought back the euros, initially placed, at a cheaper rate of 1.3400, paying USD 134,000 for EUR 100,000. The difference of USD 2,000 represents your gross profit.

By using leverage, you generate a 40% return on your original investment of USD 5,000. In case you have not used the leverage, you would only have shorted the euro equivalent of USD 5,000 or EUR 3,676.47. Each pip is only worth USD 0.36764. Closing the short euro position at 1.3400 there would be a gross profit of USD 73.53 (200 pips x USD 0.36764 per pip). Leverage overstated your income by 27.2.

An extremely high degree of leverage could result in losing much money. Some safety measures used by professional traders may help minimize the risks of leveraged forex trading:

If you aim to big gains, the first thing to learn to do is to border losses within controllable limits. Also, highly important are strategic stops, where your position can be affected by a move of a couple hundred pips in just a few hours. Stops are also used to protect profits.

Whereas the high degree of leverage in forex trading magnifies income and risks, by means of a safety measures used by professional traders may help alleviate risks.

See all 8 articles in category Forex

 
 
 
 
 
 
 
 

 
 

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