What is the single reason Forex trading is so popular? It isn’t the 24 hour accessibility of trading. It isn’t the fast paced adrenaline inducing trading. It isn’t the thrill of trading on the worlds largest and most liquid market. What is it then? One word: Leverage.
The Forex market is a very exciting place to be as a smart and capable trader. With an average daily turnover of over three trillion dollars, the Forex market is larger than all other financial markets combined. While stock traders and investors in bonds and money funds are subject to the ever changing state of the economy, Forex traders can make money in any market conditions; booms and busts, for the Forex trader it’s just another opportunity for profit. But this isn’t the real reason why so many hopeful investors try to make it there; Forex leverage is.
Here’s how leverage works: Usually when an investor makes a trade, he has a set amount of money in his account, let’s say $1000. He then buys stocks or bonds for $1000. With some brokers, the investor also has the opportunity to buy more stock than his initial investment by using leverage. By using the stock as collateral, the broker will then loan him the remainder. The current laws require that the investor must put up at least half of the investment. So, if the investor has $1000 he can buy stocks worth $2000. That is all good, but it’s hardly something that will change the game.
Suppose on the other hand, that this investor took his $1000 and opened a Forex account. Now the game changes. Unlike stocks and bonds, Forex is not regulated by a governing body, meaning there are no limits as to how much leverage can be used. Let’s say the investor takes his $1000 in a Forex account and buys one or more currency pairs. The broker, not subject to any laws, will then offer the investor to loan him up to several hundred times the value of the brokers account. This means that the investor can leverage his account 100:1, 200:1 even up to 400:1. This essentially means, that for an initial deposit of $1000, he can now trade for $100,000 and even more. How’s that for leverage? It’s easy to see why Forex trading is so tempting.
In order to trade with leverage, you need to have collateral to borrow money from your broker. This is what is known as ‘margin’. The amount of margin needed depends on the amount of leverage used. If you use 100:1 leverage, then your margin needed would be 1%. It’s important to understand that margin isn’t calculated on funds in your account, but on the total equity of your account. This includes currently open trades. Let’s say you have a Forex account with a maximum of 100:1 leverage. This means that you can trade for 100 times your equity. In the first trade that will mean you can only trade 100 times your initial deposit, but if the trade goes your way and your outstanding trades appreciate in value, then your account equity will also increase even though your account balance stays the same. Because your equity has increased you are know able to leverage your trade even more. Trading this way is highly speculative.
If the trade goes south and the value of your outstanding trades decrease, you may be subject to a ‘margin call’ from your broker. Since your account equity is now less than what is needed to maintain the leverage, the broker may require you to deposit additional funds to keep your trade open. So, while leverage can reap enormous profits, it can also make you lose your initial investment very fast. You can never lose more than the money in your account though. That means you get all the opportunity for leveraged profits, but only risk losing the unleveraged amount in your account. It’s not a bad deal.
As a beginner in Forex trading, it’s best to experiment with leverage on a demo account, with a broker such as AvaFX. You can also try leverage on a mini account where the minimum deposit can be as low as $50.