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Leverage is a concept that many new traders hardly grasp. As a tool leverage is very powerful and can potentially help you sky rocket your profits. But if used wrongly you might end up cutting off your foot! Many traders use the terms of margin and leverage interchangeably. Understand that margin and leverage are two very different aspects and cannot be used interchangeably.
What exactly is leverage? The general definition of leverage is: "The mechanical power or advantage gained through using a lever" Bear in mind this definition is very apt and when you think of it in Forex terms we can say that leverage in Forex as defined in www.freedictionary.com:
"The use of credit or borrowed funds to improve one's speculative capacity and increase the rate of return from an investment, as in buying securities on margin"
We can define Margin as:
"The amount of collateral a customer deposits with a broker when borrowing from the broker to buy securities"
In Forex, what you do is that you use your deposit in your account to borrow from the broker to trade. Of course that also means that you cannot borrow unrealistic sums of money. The Broker would have calculated your risk position in relation to his thus you see things like 1:100, or 1:500. That means with your margin of $1 you can borrow up to $500 to trade in forex. Without such borrowing, a common person cannot be possibly able to take all his resource to trade on the Forex market.
There are dangers to over leverage as well and what we call a margin call. A margin call occurs when the money in your account is in sufficient to keep your position in place. That means that you have lost so much money that the broker in order to protect his interest has closed all your positions to recoup his losses. A margin call is bad and shows poor money management skills. You should never be in that position as you have started out well taking on maximum5% of your account to trade. Greed kills an account very quickly. Over leverage and margin calls are two big no-no for traders!
So leverage is what you borrow from the broker to use in your trading. While Margin is what you use to fund your trade. Margin belongs to you, it is your money. Leverage is the broker's money; if you lose it then they will take your money to pay it back. How they do that is they close your position and take all your cash from that trade.
Leverage is a very powerful tool, imagine using $1,000 to control $100,000. If you started your trading with no leverage the maximum you could go was $1,000. With leverage you can do a hundred times of that amount.
What then is proper leverage? This really depends on the trader's risk appetite and your money management rules. I would suggest that the maximum cap be 1:200, but the best leverage to take would anything below 1:100. Over leverage kills as quickly as it can make you money, with proper controls you can supercharge your trading without controls you can expect an account wipe. Thus harness the power of proper leverage and make your trading profits soar!
About the author:
Dr. Joshua Geralds is a successful investment specialist with over twenty years experience increasing the income of people world wide. For a limited time get his free Money Management to a Million Dollars e-course here: http://www.pipsalot.com
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