One of the major advantages of the spot forex market is the ability to use leverage to control a larger position than would otherwise be possible in more traditional markets.
Most spot forex dealers offer leverage of 100:1 up to 400:1. Your amount of available leverage is usually determined when you open your account and cannot be changed from trade to trade. It remains consistent across all your trading activity.
At 100:1, a trader is able to control $100 for every dollar he or she trades. This means that with a $1,000 deposit, you could control up to $100,000 of capital. This allows you to reap more potential profits than would otherwise be possible.
It’s important to note, though, that leverage can amplify both profits and losses. All traders must practice sound risk management to help ensure that they don’t end up losing more than their original stake. It’s also important to understand that forex is inherently risky. Traders should never risk more capital than they can afford to lose.
So how does leverage work in a forex trade?
Let’s say you’re considering trading the EUR/USD. After researching the pair, your analysis suggests that it is set to move up from its current price (1.3015), so you decide to go long. Because your leverage is set at 100:1, you can buy one lot (100,000 units) for $1,000. Later in the day, you notice that the EUR/USD is now quoted at 1.3070. Your trade has gained 55 pips. Because each pip is worth roughly $10, your profit would be more than $500. That’s not bad for an initial outlay of just $1,000.
Conversely, if your trade had moved against you 55 pips, you would have lost roughly the same amount – more than half of your original stake. That’s why many professional traders recommend at least a 3:1 risk-to-reward ratio, meaning that with any trade, your potential reward outweighs your potential risk by 3-to-1.
It’s important to have a strong trading plan, including a risk-management system against which you can weigh each potential trade. If the trade doesn’t fit the criteria you’ve laid out in your trading plan, you shouldn’t place the trade, no matter how much of a “sure thing” you think it might be.
Brendan Gunn, Sales Manager, GFT
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This information is for illustration purposes only and does not indicate a recommendation for a particular trading strategy.