There is no disputing that trading leveraged products such as Margin Forex can be an effective and simple way of gaining exposure to your desired currency pair. However it’s imperative that every trader develop a deep understanding of what it means to trade with leverage before putting their hard-earned cash on the line! Let’s start by exploring the basics of what it means to trade with leverage.
Sometimes referred to as “gearing”, leverage is the ability to control an asset with only a portion of its value. In the case of Forex trading, sometimes that can be as 500 times your initial capital outlay!
Leverage has been used by institutions for many years but has only been made widely available to retail traders with the introduction of Contracts for Difference and Spread Betting in the late 1990’s. Whatever the way you spin it, its clear leverage can work both for and against traders and experience shows in some cases a misunderstood concept.
Let’s use the Aussie dollar (AUD/USD) pair to illustrate how leverage works. A trader wishes to buy A$10,000 in anticipation of it increasing against the US dollar. Clearly if you were to go to your local money exchange, you’d need to stump up A$10,000 and you’d be handed back around US$9,200 at current rates. However trading with a forex broker, you only require a fraction of the total value to get the same A$10,000 exposure. Some foreign exchange brokers will offer up to 30:1 leverage, meaning that only 1/500 (0.2%) of the contract needs to paid up front, therefore enabling a trader to open a position to the sum of A$10,000 for an initial outlay (“margin”) of $200. For the trader to double (or lose) their entire initial outlay of $200, the currency pair would only have to move by 0.2% due to the amount of leverage used (0.002 x 500). Whilst this may present a lucrative opportunity to trade in sizable volume, it can work in both directions and requires careful risk assessment by the trader.
When capital is borrowed interest comes into the picture, and it’s no different in the Forex world. When trading FX, the interest component is known as a “swap” which is paid or received depending on the currencies you are buying and selling.
Most transactions in the forex market are conducted using leverage in some way, shape or form. Many would argue that without the use of leverage success in currency trading would be difficult to achieve, solely relying on capital gains and interest rate differentials at the mercy of economics. On the other hand, many that trade using leverage ignore the scale to which they are trading and are subsequently backed into corners by only small fluctuations in prices. Consequently, an understanding of leverage is crucial to your trading success.
For more resource on Forex trading check out our Forex Trading For Beginners introduction, Forex Trading Courses, open a Forex Demo Account or open a live Forex Trading Account. See here for more information on leverage in Forex trading.
Disclaimer: Articles are from GO Markets analysts and contributors and are based on their independent analysis or personal experiences. Views, opinions or trading styles expressed are their own, and should not be taken as either representative of or shared by GO Markets. Advice, if any, is of a ‘general’ nature and not based on your personal objectives, financial situation or needs. Consider how appropriate the advice, if any, is to your objectives, financial situation and needs, before acting on the advice. If the advice relates to acquiring a particular financial product, you should obtain and consider the Product Disclosure Statement (PDS) and Financial Services Guide (FSG) for that product before making any decisions.
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