Leverage means being able to trade forex using borrowed capital. Why is this necessary? – Basically, because fluctuations in exchange rates tend to be very small and you would need a lot of capital in order to make any kind of substantial profit. To illustrate, let’s say that at the start of the week, you bought ten UK pounds when the exchange rate was 1GBP: 146.29174 KES. At the end of the week, the exchange rate had fluctuated to 1:146.65699. This means that you would have made a profit of only 3.6525 if you chose to sell your pounds.
Another thing to keep in mind is that currencies are sold in lots. The standard lot size is 100,000 units although mini-lots of 10,000 units and micro-lots of 1,000 units are also available. But what this means is that in order to trade even the smallest lot size, assuming an exchange rate of 1:146.29174, you would need at least 146,292 KES. Unless you have that amount of capital handy, you will need to avail of leverage in order to enter a trade.
Forex brokers offer leverage to traders who are signed up with them, but require that you put up a certain amount of money in your trading account. This amount is called the margin and how much you need to deposit depends on the leverage you are given. To illustrate, let’s say that we want to buy a micro-lot of 1,000 GBP. If the broker offers us leverage of 200:1, we would need to put up only .05% of the total amount of the position traded or 7,315 KES. If the broker were offering 400:1 leverage, we would need to put up only .25% of the amount or 3,658 KES. The amount of leverage offered by brokers ranges from a low of 20:1 (which would require a 2% margin) to a maximum of 400:1.
Thus, in exchange for only putting up a small amount of money, we would be able to greatly maximize the size of the position we can trade, and of course, substantially increase our potential profits. Of course, the opposite is also true. If the trade we are making moves against us, it can greatly magnify our losses, which can add up very quickly.
Another thing to remember when availing of leverage is that you need to maintain the minimum margin in your account. If you suffer a loss and you don’t have the required amount, the broker can trigger a margin call. The margin effectively acts as the collateral for the money the broker is lending you and thus, if the amount of money in your account falls below the required minimum, you will be required to deposit more into your account.
In addition, the broker may also trigger a margin closeout. The way this works is that your broker is always calculating the unrealized value of your open positions, which is known as your Net Asset Value. If your positions start to lose a lot of NAV, to the point where the amount in your account may fall below the required minimum margin, the broker may choose to automatically close your open positions. Of course, you can avoid this by monitoring the amount of money in your account and ensuring that it stays within the required minimum.
Thus, it is important that a trader learn to use leverage carefully in order to maximize profits. He should learn to use the right amount of leverage rather than just availing of the highest leverage available. In addition, the trader should learn to use safety measures such as stop-loss orders in order to prevent his losses from becoming too big and triggering a margin call or closeout.