The double edged sword Leverage in Forex can be deceiving

Most professional Forex traders trade with only one lot for every 50,000 that they have in their account. To clarify, one standard lot is equal to 100,000 and it equates to a leverage of 1: 2.

So how come most amateur traders trade with standard lots, but with only 2,000 in their account?

It doesn’t matter if your broker gives you a leverage 1: 100 or even of 1: 400 and it doesn’t matter if he tells you that you can also open an account with 100 euros. The major cause of failure of new traders in Forex is not because they are not good enough, it’s because they don’t have enough capital. And they do not understand how the leverage in Forex works.

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How the leverage in Forex works: handle with care

In Forex, thanks to leverage you can control a capital of 100,000 with only 1000. In this case, you have a leverage of 1: 100. Or rather you put in 1000 and the broker will “lend” 99,000. Sounds great doesn’t it?

Imagine what happens if your trade gains 1%. You earn 100%. You put it in 1000 and have earned another 1000!

Doesn’t it sound great? Of course, the whole thing can work in reverse. If you manage 100,000 in your trade and you put 1000 and the trade loses 1% you lose your $ 1,000.

How fast does a trade on Forex gain or lose 1%? It depends on so many factors. If there was some news update it could be a few minutes. We say that if 1% of movement requires a minimum time of 0.25%, things can change in a matter of seconds. It can happen that 250 is earned (or lost) in a matter of seconds, thanks to, or rather due to, a leverage of 1: 100!

A problem can arise if with too little capital, you purchase more than one lot. Then you get the dreaded margin call.

That damn margin call

Let’s say you opened an account with 5000 euro. You use a leverage of 1: 100 and choose to make a trade on EUR / USD. With a lot of 100,000 you have to put in 1000, as we have already seen. But you feel overly confident and you say to yourself: “I think this trade will work, I will take 4 lots”. With a total of € 4000 you handle 400,000 euro. If it works you’ll make a lot of money.

Unfortunately you did not see that the EUR / USD lost 25 pips in 1 minute. It can happen. It’s normal. This means losing about 250 Euros. Multiplied by 4 lots is 1,000 euro. You think what you are going to do and you know that you can wait and that the trade might go in your direction. And then you get it.

BEEEEP! Margin Call!

Bam! The broker closes your trade and you say goodbye to 1,000 euro. Why?

Because you exceeded the usable margin, this means the reserve money that you always have. You only had 1,000 euro of usable margin and the trade exceeded this, you receive the margin call and you must say bye bye to your 1,000 euros. You lost 20% of your account in one minute.

This is the danger of using a high leverage with a small capital. For this reason professional traders keep at least 50,000 for every lot. In this example you have tried using 4 lots with 5000! A risk 40 times higher.

I hope I have made you understand the dangers of leverage in Forex. They must be handled with care and with proper precautions.

What precautions? We will look at these next week.

Until the next appointment with your financial freedom,
Alfio Bardolla

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