This article details leverage and its uses on the foreign exchange Melbourne market.
Traders are attracted to the foreign exchange market for various reasons, one including the levels of leverage on offer. The majority of financial trading markets do allow the use of leverage; however, not all of them offer the same quantity as the foreign exchange market. While many traders have heard of leverage, there are few who understand the concept fully.
Leverage and leverage calculations
Leverage can be described as a loan because you are borrowing a certain amount of money from your forex broker in order to purchase large trading lots. This is generally done by traders using mini or standard accounts as they have minimal trading account capital, and with leverage can trade large lots using this minimal capital.
To calculate the amount of leverage required to complete a trade you must divide the value of the transaction by the margin you will be required to put up. To calculate real leverage you must divide the value of the trade by the capital in your trading account. This calculation is important as it is the real leverage that presents the risk, not the margin-based leverage.
The use of leverage when trading
Foreign exchange trading is about profit and loss. The use of leverage allows you to utilise a relatively small amount of trading capital and purchase large amounts of currency. It is only these larger trades that show market movements associated with a substantial profit. A profitable trade with leverage can be highly beneficial; however, you must be sure to relate the levels of leverage used to your trading style and the risk management techniques you have in place.
The risk of leverage on the foreign exchange Melbourne market
Although real leverage has the ability to make you a great deal of potential profits, it can also cause detrimental losses if the trade turns against you. The higher the level of leverage used the greater the risk of the trade in question.
When utilising leverage you must also consider the rules of effective foreign exchange trading, with the cardinal rule being that you must never risk more than 2% of your trading capital on a single trade. It is important to calculate whether or not the leverage being used will risk more than the mentioned 2%.
For example, two foreign exchange traders have £10,000 capital in their trading account. Trader A will be using 50 times real leverage, and trader B will be using 5 times real leverage. The value of the trade for trader A, when using the leverage, will be £500,000; whereas, the value of the trade for trader B, when using leverage, will be £50,000. If there is a 100 pip movement against both traders then trader A has a chance of losing £4,150 which is above 40% of their trading account capital. However, when facing the same 100 pip movement, trader B has a chance of losing £415 which only 4% of the account capital.
It is highly recommended that you calculate how much capital you could lose before utilising leverage. This will help determine how much leverage you should use, if using any at all.
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