Best Leverage Ratio for Forex Trading
Whether you are a novice trader in the Forex market or an experienced professional trader, you must have come across the term leverage. If you are new to Forex trading, you may be wondering what exactly this term means. In this case, I recommend you to read the article “What is Leverage”.
Since the world’s leading brokers offer different forex leverage ratios, here we will review the main points of trading with this financial instrument and try to answer the following questions: What is a good leverage ratio? But first, let’s understand this important concept.
What is the leverage ratio?
Forex leverage is the amount of trading funds that a broker is willing to lend you to invest based on the ratio of your funds to the amount of credit.
The total amount of leverage offered by brokers is not constant. Brokers set their ratios, which in some cases can go as high as 1:100 or even higher. Forex leverage is mostly expressed as a ratio. In this example, this means that for $1 you can open a position for up to $100.
What leverage ratio is suitable for novice traders?
Let’s figure out what is the best leverage for novice traders. Many novice traders are attracted by leveraged money-making strategies because they want to make more money in a short period of time.
However, keep in mind that leverage is associated with certain risks. At a minimum, you need to understand the concepts directly related to money management in leveraged trading, such as:
- The balance and equity of your account;
- Security deposit;
- Free margin;
- Account level;
- Margin calls and stop losses.
This will also help novice traders in the forex market weigh the pros and cons of using leverage and make a sensible determination of what leverage you need.
The benefits of using leverage
First, let’s take a look at the benefits of leverage for novice traders:
1. Opportunity to earn super profits
Traders use leverage in the forex market to increase their initial investment in order to make larger trades.
Best Leverage Ratio Example:
For example, a trader with only $1,000 in his account can actually trade for $50,000 with 1:50 leverage or $100,000 with 1:100 leverage in the foreign exchange market. Simply put, the trader risked losing $1,000 of his own capital by opening a position with full margin and 1:100 leverage, and if the trade was successful, he would have made a profit of $100,000.
2. Improve capital efficiency
For example, if your account balance is $1000 and you use 1:100 leverage, you can actually manage $100,000. This means you have the opportunity to trade more with a variety of trading tools and apply hedging strategies to improve risk prevention. This diversifies your portfolio, reduces risk, and increases your chances of making a profit.
3. Low transaction threshold
Let’s use the previous example to illustrate this advantage – you have $1000 on your account. Assuming you do not use leverage, that is, your trading leverage is 1:1.
Under this condition, you can only open a position with a minimum lot size of 0.01, not even with the EUR/USD (Euro/USD) currency pair.
This is because in Forex, one lot is usually equal to 100,000 currency units. In other words, to open the smallest position in EURUSD (EUR/USD), one of the most traded currency pairs on the Forex market, you would need 100,000 * 0.01 * 1.17470 = $1,174.70.
If you have $1000 in your account and you don’t use leverage, you can’t open even the smallest positions. However, by using high leverage, even those with small deposits of $50 to $100 have the opportunity to learn the art of trading and trade like a professional trader.
4. Favourable financial conditions
Previously, when brokers did not offer leverage, the only opportunity to trade with leverage was to start trading by borrowing limited funds from the bank with high-interest rates, huge collateral and guarantees.
In the face of fierce competition, Forex brokers offer high leverage to attract clients with small deposits and minimal commissions. Leverage is almost free if you day trade. If you decide to trade overnight, take into account SWAP (Swap Interest) – this is the broker’s overnight commission.
Traders using high leverage can easily earn 300-500% monthly profit margins, which are higher than any bank rates.
It is important to understand that a qualified broker’s main income comes from commissions, SWAP (swap interest) and spreads for opening trades. Therefore, it is very important for brokers that each client use their services for as long as possible, to be successful in trading and to become rich. A qualified broker doesn’t want you to drain your entire deposit and then swear off Forex trading in the future.
Therefore, in this highly competitive environment, Forex brokers offer leverage for you to choose from with favorable conditions such as low interest rates, flexible rate schedules and lowest commissions. Reputable brokers even offer personal manager services. A personal manager will help you understand all the nuances, choose the best leverage, and balance your trading strategy.
You may have heard of margin calls. Many traders were taken aback by these two words. But in fact, this feature is there to protect your deposit. Unfortunately, novice traders often misjudge the risks they face. When a broker realizes that your risk of losing your deposit is high, they will call you or send you an automated message telling you that your account balance needs to be replenished to deal with the high risk.
Sometimes inadvertent traders forget about leverage and the debt associated with it. They became debtors to the company by engaging in unreasonable transactions. To avoid this situation, use the service provided by the broker, which guarantees that the account balance is zero when the trade is cleared. With this feature, you will never lose more than your balance
Disadvantages of Forex Leverage
However, leverage also has a downside. Novice traders should pay special attention to the disadvantages of Forex leverage.
Let’s take a closer look:
1. High risk of losing your deposit
This risk is that traders are prone to falling into a psychological trap when using high leverage. You will feel like you have a lot of spare cash that you need to use to make some investments. It is important for every novice trader to remember that leverage not only provides additional opportunities but also creates debt. The most important point is to cover losses with your own funds to avoid stop losses (you can find detailed instructions and examples here). Due to the high leverage, you can open positions hundreds of times larger than your real funds, which can lead to huge losses on your balance. This is especially dangerous when you open several large positions at once. If you suffer a loss on one of your trades, the account level of all your other open positions will be lowered and your stop loss risk on those trades will increase. In other words, if you abuse your free margin, your position structure will collapse like a house of cards in an instant, burning your deposit.
2. It is difficult to recover the deposit
As mentioned above, your balance is vulnerable to huge losses when using high leverage. Newbies naively think that due to the high leverage, it is easy to get the account back to the previous balance. But you should always keep in mind that to cover losses, profit margins must be many times higher. For example, if your balance is $100 and you lose 50%, to get back to breakeven, you need to make a 100% profit from your $50 balance.
Below is a table showing the profit margin that returns to breakeven in the event of a loss. I recommend that you print out this form and keep it in front of your work screen to remind you of your risk management rules.
With high leverage, as your balance loses, your purchasing power also decreases, and less funds are available for collateral, so the risk of stop loss increases. Losses are usually made up by reducing open positions, which in turn reduces potential profit margins, i.e., making it harder to recover deposits in the end.
It is important to always remember that using low, medium or maximum leverage in the Forex market is a commitment. Whether you succeed or fail at the end of the trading day, you’ll get back the prime value of your leverage in the form of overnight interest. Leverage costs must be paid from the trader’s account and will be automatically deducted from their balance.
A swap is a leveraged commission that is automatically withdrawn from a trader’s balance. Clearly, the cost of leverage depends directly on how much it is used. Brokers usually only charge a commission on the amount of funds actually used.