Understanding the Risks of Leverage in the Forex
Before you begin to trade in the forex, it is vital that you get familiar with the fundamentals of leverage. If you are trading in a demo account, it is a good idea to try it there first, to get an idea of the potential for profits and risks. This cannot be overstressed.
All to often, misconceptions and misuse of leverage in the forex have led to heavy financial losses for a lot of traders. Leverage, it simple terms, simply means that you will be able to trade with more money than is deposited in your account.
For a new forex trader, the attraction is understandable; it allows him to open an account for a little as $250 or $300, and using leverage in the forex, can end up controlling and earning hundreds of thousands of dollars.
For instance, it is easy to spot a forex firm offering a 100:1 leverage. What this means is that for a $1,000 dollar account, you can trade with $100,000.; a 200:1 ratio means you can buy and sell with $200,000. Some brokers offer ratios as high as 400:1. If you start with $200, that translates to over $80,000.
Leverage is expressed in these ratios, although they are also articulated in percentage of margin required (2% margin =50:1, 1% margin =100:1 and .25%=400:1). The lower the margin, the higher leverage.
The idea that you can invest very little capital and earn thousands of dollars in return makes leverage an attractive prospect for those who do not want to invest a lot of money in the forex, but the risk is that it will only take a small movement in the market to wipe out your account.
Assuming that you open a mini account worth $500 and use a 200:1 leverage; that translates to $200,000 you are currently controlling. If you purchase a USD/JPY pair (at a Dollar per pip) and set your Stop/Loss to execute at the 50 pip level, it means that once the USD/JPY falls to that level you would have lost almost 10% of your account.
It is not uncommon for currency pairs to move in one direction for long periods of time, and before you know it, the money in your forex account has dropped to the lowest level, and you will get the margin call.
This scenario is not limited with micro or mini accounts. If you have a $50,000 forex account and utilize a 200:1 leverage then it will only take a few pips to make a fortune or lose your entire account. The point here is that the higher the leverage the greater is your exposure to risk.
You will not save money by opening a mini account and using a high leverage; instead you will just expose to risk what little money you invested in your forex account. That is why a lot of traders prefer to start with a sizeable deposit ($50,000 at least) and minimum leverage (3:1 at most). With this setup, the risk is smaller.
Scrimping on funds is never a good way to start a business, and that is the attitude you should carry when you decide to trade in the forex. It is better to save up for the necessary capital, and only when you have the experience and financial capability, should try the higher leverage, if at all.
There are other aspects about leverage that you will read and learn about, but the basic fact is that the higher it is, the more dangerous. Opt for a sizeable capital instead, and you will be all right.