Yes, Forex trading is just like driving a Ferrari.
You can go very fast, incredibly fast, win the race and quickly accumulate gains.
But you can also have very bad accidents if you don’t know how to drive the beast!
Forex makes it possible for you to manage big amounts of cash without the need to have this cash in your account.
This lovely and dangerous thing has two names, a bit like a dragon with 2 heads, which are called: margin and leverage.
The margin is the security that you must deposit with your broker for a foreign exchange trade.
A margin of 0.5% means that you use a guarantee of €500 when executing a trade of €100,000 (€500 is 0.5% of €100,000).
Margin trading is simply the term used for trading with borrowed capital.
The leverage, the second head of the dragon, is the reciprocal value of the margin.
A margin of 0.5% equals a leverage of 200:1. When you buy and sell foreign currencies with a leverage of 200:1, it means that with €500 in your Forex broker account you can trade 200 times that amount, i.e. €100,000 in a Forex trade.
Typically the broker will require a trade deposit, also known as the “account margin” or “initial margin”: the first head of the dragon.
Once you have deposited your money you will then be able to trade.
For example, if the allowed leverage is 100:1 (or 1% of position required), and you wanted to trade a position worth €100,000 but you only have €5,000 in your account, it is possible!
Your broker would then set aside €1,000 as a down payment, or the “margin,” and let you “borrow” the rest.
Of course, any losses or gains will be deducted or added to the remaining cash balance in your account.
You might have already realised what a low margin (respectively a high leverage) implies: large potential gains but a high level of risk (especially if you don’t know what you are doing).
The amount of leverage you use will depend on your broker and what you feel comfortable with.
LET’S LOOK AT AN EXAMPLE:
Going ‘Long’ with leverage in Forex
We wish to buy (go ‘long’) the EUR/USD currency pair by buying €100,000 at the current market rate of 1.2130.
At 100:1 leverage, our broker takes just €1,000 worth of US Dollars from our account as the margin/deposit needed for the purchase, whilst he lends us the other €99,000 worth of dollars required.
You buy €100,000 at the market exchange rate of 1.2130.
1 day later, you sell your €100,000 back at the new market rate of 1.2210 (up 80 pips)
Profit on the trade = $122,100 (sale price) – $121,300 (original cost) = +800
Because the exchange rate between the Euro and the US Dollar went up over night 80 pips and you sell at the new rate of 1.2210, you make a profit of $800.
Please bear in mind that if you didn’t know what you were doing, the situation could have been reversed and if the exchange rate had fallen 80 pips before selling, you would have lost $800!
In Forex trading, like with any other skill, it is very important to master it in order to consistently make money…
All in all, leverage is a double edge sword and whilst it allows educated traders to make exaggerated profits, it has the opposite effect on losses too.
That being said, with the right trade management and capital management (as the one we deliver here at http://SurfingThePips.com) you will be able to use leverage in the right way, drive the Ferrari till the end of the race, and win it the vast majority of the time…
Why does leveraged trading exist?
In the Forex market, leveraged trading exists to create the possibility of making a bigger profit. Leverage is necessary because Forex trades involve very small differences in price.
As low as a very small part of one cent…
With such small amounts, it can take a long time to make a meaningful profit, as well as bigger initial investments.
Using leverage, you can get a return on your investment much faster and using smaller initial deposits!
High Leverage and Low Margin: Good or Bad?
The greater the leverage, the more profit you can achieve with a certain capital, but the higher your risk is. Hence, high leverage is not better or worse than lower leverage:
The higher potential rate of return is offset by a higher risk of loss.
But if you are using a system like the one we use at http://SurfingThePips.com, you could be making fantastic money using leverages while minimising the risks of losses!
Read next post, as you will learn how it is possible to trade the Forex in the comfort of your home…