Leverage in Forex: Simplifying the Complex

We're happy to welcome you to a new educational article! Are you ready to absorb knowledge? We know you do. Imagine you have $100, but you want to try to earn more than this amount allows. This is where the ability to use borrowed funds comes into play—a kind of "turbo boost" for trading. It allows you to trade with amounts significantly larger than your capital, using funds provided by the broker. However, as with any superpower, it's crucial to know how to use it to avoid getting into trouble. So, let's get into it.

What's Leverage

Leverage is the ratio between your own money and the funds the broker lends you. For example, a ratio of 1:100 means that for every dollar you have, the broker "adds" another $99, allowing you to control an amount 100 times larger than your deposit.

Let's say you want to buy an expensive bicycle, but you only have $100. You rent a high-end bike (analogous to a loan), ride it, win a competition (a successful trade), and take home the prize. But if you fall (an unsuccessful trade), you'll have to pay for the repairs (losses).

How It Works

Borrowed funds amplify not only profits but also potential losses. Let's break it down with an example:

Without leverage: you have $1,000, and you buy the EUR/USD currency pair. If the price increases by 110.

With 1:100: you can open a trade for 100,000. With the same 1% growth, your profit is already $1,000! But if the price drops, your losses will also increase 100 times.

Leverage does provide traders with a great opportunity to maximize their profits, but if you don’t manage risks wisely, you might find yourself struggling to get back on track after a series of unfortunate trades.

Key Terms for Beginners

If trading jargon seems like a magical language to you, here’s a translation of the main terms:

• Margin — the amount the broker "freezes" in your account as collateral.
• Margin Call — a signal that your account balance is too low, and the broker may close your position.
• Liquidation — the automatic closure of a trade by the broker if there isn’t enough money in your account.
• Stop Loss — insurance that closes a trade when a certain loss level is reached.
• Take Profit — a profit lock that automatically closes a trade when the target is reached.

These terms are not just technical jargon but essential concepts, often meticulously explained by brokers and trading experts to ensure traders can navigate the market with confidence.

Pros and Cons

All controversial aspects are best understood through comparison. Let’s apply this idea by highlighting the clear advantages and disadvantages.

Pros:

• Start small: Even with a small capital, you can work with large trades.
• Chance for good profit: If done correctly, you can significantly increase your earnings.
• Flexibility: You can choose different borrowing levels depending on your experience and trading style.

Cons:

• Increased risks: You can quickly lose your entire deposit if the market moves against you.
• Stress: Using borrowed money makes trading more thrilling and emotionally challenging.
• Dependence on the broker: Brokers set margin conditions, and if you don’t comply, trades may be closed automatically.

Since leverage magnifies both profits and losses, it requires a much greater  approach, meaning traders must always have a risk management strategy in place.

How to Safely Use Borrowed Funds

Here are some practical tips for those primarily concerned with the correct use of leverage:

Start small: It’s better to use a ratio of 1:10 or 1:20 until you understand the mechanics.

Use stop-losses: They help limit losses and prevent you from losing your entire deposit in one go.

Don’t put all your eggs in one basket: Diversify your trades; don’t risk your entire capital.

Practice on a demo account: Before entering the real market, try your strategy risk-free.

Maintain balance: Keep an eye on your margin to avoid an unpleasant "margin call."

In fact, these tips should be followed by everyone, as they are the key to trouble-free trading. The last thing you want during trading is to face problems due to a lack of understanding of basic principles, so we recommend keeping this in mind. Even experienced traders can struggle if they lose control over their emotions, leading to impulsive decisions and unnecessary risks.

Parallels from Other Fields

To better understand how borrowed funds work, let’s look at a few examples for "dummies":

• Car loan: You buy a car with borrowed money, and while it increases your mobility, you also have to make regular payments. If you fail to pay, the car may be repossessed.
• Mortgage: You purchase a house with a loan, and while it allows you to own property, you also take on the responsibility of monthly payments and the risk of losing the house if you default.

These examples illustrate how leverage can amplify both opportunities and risks, just like in Forex trading.

Trading styles

It's no secret that different trading styles require different approaches to existing tools. The same goes with using leverage:

• Scalping (many trades per day): The highest ratios (1:50 - 1:200) are used, as positions close quickly.
  Day trading: Moderate leverage (1:10 - 1:100), trades are opened and closed throughout the day.
• Long-term trading: Low ratios (1:5 - 1:20), as trades can stay open for weeks.
• For traders following Islamic finance principles, it's important to note that conventional leveraged trading might be considered haram, as it involves interest (riba), which is prohibited in Islamic law. However, some brokers offer swap-free accounts that comply with Sharia principles.

Summarizing

Warning: the article is finished. We are ready to draw conclusions! Leveraging is a cool tool if used wisely. It can increase profits, but it can also zero out your deposit quickly. The main thing is to keep the balance, not to risk the whole amount and not to trade on emotions. Start small, learn, train, and then Forex may become not a lottery but a source of stable income for you.