Your analysis and conviction dictates you that EURO will appreciate to a level of 1.5600. In anticipation you buy 1000 EURO/USD at 1.5550. As a matter of fact you have bought 1000 EURO by paying 1555 USD. Your trade turns in your favor and the exchange rate goes up to 1.5600. Immediately you sell 1000 EURO/USD at 1.5600. You have sold your 1000 EURO in exchange for 1560 USD. Let us work out the profit under two different scenarios.
- Without leverage: Profit = 1000 x (1.5600 – 1.5550) = 5 USD. Your return on investment (ROI) is 0.5%.
- With leverage: Let us presume that your forex trading broker has given you a leverage of 100:1 Now with the same investment of 1000$, you are in a position to buy 100,000 EURO/USD. Profit = 100,000 x (1.5600 – 1.5550) = 500 USD. Your ROI is 50%.
Don’t you think that magic of leverage creates wonders? Well, it does, but let me caution you that there are dark sides as well. Suppose if the trade went against you and EURO/USD fell to 1.5500. You will land up with a loss of 5$ without leverage but the loss would be 500$ with leverage. Do you realize the actual implications? You have ended up with a loss of 50% of your capital in just one trade.
Summing Up
- Risk management is an extremely important function in forex trading.
- Risk management and surveillance systems followed by forex trading brokers and forex trading company are different. In case your forex trading position is making huge losses, you may be called upon to jack up your margins. It may happen that in the event of acute volatile market conditions your loss making position would be squared off automatically