Leverage, in fx trading, can either be your best friend or your worst enemy. If you study the subject well, before ever starting to trade fx, then you probably have a friend for life. If, on the other hand, you think that you know all about debt and don’t need any more edification on the subject, then “it was nice knowing ya”. Why? Well, unless you have traded futures before, you’re not used to trading on a “marked to market” basis and, therein, is the real rub. Simply put, anything that is “marked to market” (and everything that you trade in fx is) means that the value changes with the market. Since fx is global, it doesn’t sleep. So, neither does the value of your fx trade (up or down). Obviously, a whole different mindset is needed to successfully trade in such an environment. That’s why doing your homework – about leverage – before you start trading is so important.
A high fx leverage ratio can murder your trade. If you’re a beginner, think defensively.
Leverage For FX Traders: The Basics
Leverage is the financial term for borrowing money for an investment. For example, if you plunk down 1% of the value of a transaction, then you have a leverage ratio of 100:1. If you put down 2% cash, then you have a leverage ratio of 50:1. If you place 5% in a cash margin account, then you’re trading on a “20:1 ratio basis”. In other words, the more cash you put down, the lower the fx leverage ratio (or, the less cash you put down, the higher the leverage ratio). Banks and brokers love you if you use high leverage ratios because this means that you can trade more forex contracts (which means that they get more fees out of you).
Can FX Leverage Be A Bad Thing?
By itself, using a relatively high leverage ratio is not a bad thing. What people tend to forget – and where things start to go haywire – is that, in fx trading, all open trades are constantly being “marked to market”. This means that your trade is being judged every second of the day and night while it is open and your profit/loss statement can change just as fast. So, if you only have a little cash down (i. e., you’re using a leverage ratio of 100:1 or higher), then that cash down can disappear very rapidly if the fx market you are in becomes more volatile and price spikes begin to occur. Once your cash margin disappears, your fx trade is dead.
Moderation With FX Leverage Is The Key
FX newbies need to think defensively. This means only trading currency pairs that are relatively non-volatile. [Use an “Average True Range” (“ATR”) indicator, on a daily chart, to help you figure this out.] This also means trading during regional market times that aren’t so volatile (e. g., late in the Asian trading session or late in the European trading session). Lastly, reduce the amount of leverage you’re using! There’s nothing wrong with a ratio of 10:1 (i. e., putting down 10% cash) or 20:1 (i. e., putting down 5% cash). It still, probably, beats anything you can do in the stock or real estate markets, doesn’t it? Protecting your cash pile is your no. 1 goal, then making a profit.