Credit Leverage at forex
Credit Leverage - is the borrowed funds that a brokerage company provides to a trader. The leverage size could be 1:4, 1:100 or any other value. Leverage 1:100 means that you can have 1% of the transaction size on the personal account in order to open it.
Leverage and margin
Margin (pledge) means temporarily blocked funds on the trading account for the purpose to open a certain position with a certain leverage. The margin serves as insurance for the broker to protect own funds in case of unprofitable trade or trades. The amount of margin depends on the maximum allowable leverage and the size of the position to be opened. The larger the allowable leverage, the lower the margin required to open a position.
On account $ 1000, the leverage is 1: 100. We assume that the euro will rise against the dollar and decide to buy 0.01 lot of EURUSD (1000 euros). For 1 euro, they give 1.3010 dollars, that means 1000 euros worth 1301.0 dollars. Without a leverage, our margin would be 1301.0 dollars and we would not have enough money on the account to open such position. But with a leverage of 1: 100, the margin decreases 100 times and equal $ 13.01 for 0.01 lot size, which will allow us to buy approximately 77,000 euros (100,000 / 1,3010) or 0.77 lots.
The term "leverage" is one of the main ones in the forex markets, so let's take a look at the examples of how the leverage affects trade.
Situation 1 - without leverage
You have $ 500 on your account. You bought 10 shares for $ 50 each. After the purchase, the shares became cheaper and you sold them at $ 49 each. Now your account is $ 490. Here everything is simple.
Situation 2 - use of the leverage of 1: 100 (shares have fallen in price)
You have $ 500 on your account and a leverage of 1: 100, which gives you the opportunity to trade for $ 50,000. You bought 1,000 shares for $ 50. Shares fell in price by $ 0.5 and you sold them for $ 49.5 apiece. Your loss was $ 500 (50 - 49.5 * $ 1000).
Shares fell by only 50 cents, but due to the shoulder of 1 to 100, the loss increased 100 times.
Why did it happen?
The essence of the leverage is that the broker allows it to be used as long as there are enough funds for margin requirements on your trade account.
Once your losses become equal to the initial balance of the account (before using the leverage), the transaction is automatically closed. It turns out that if you did not sell the shares at a price of $ 49.5 per piece, the broker would have done it for you and closed the deal, since the drawdown was $ 500 - the amount of your initial balance and more than it could not be.
Situation 3 - use of the leverage of 1: 100 (shares rose in price)
You have $ 500 on your account and a leverage of 1: 100, which makes it possible to trade for $ 50,000. You bought 1,000 shares for $ 50. Shares have risen in price and now cost $ 52 and you sell them. The balance of the account after the sale is $ 52,000 - $ 50,000 (leverage) = $ 2,000, which is 4 times the initial deposit.
As you can see, leverage gives you the opportunity to both significantly increase your income, and quickly remain with nothing. How to minimize risks when using leverage? There are 2 ways:
1) Do not open a maximum position size with a big leverage.
Having a leverage does not make you obligated to use all your funds. Follow the pre-designed trading strategy.
2) Set up the stop-loss order.
Stop-loss is a condition in which a loss-making position is closed at a predetermined level.
Let's return to situation 2. If the stop-loss was set at $ 49.8 per share, then the deal would automatically close at a stock price drop to $ 49.8, which would result in $ 300 ($ 49,800 - $ 49,500) remaining on the account.
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