Have you ever wondered how forex traders make the very high profits that they make?

I mean, their profits are calculated based on pips and there usually isn’t much pip movement.

A pip is just a thousandth of a cent, and you may find someone celebrating a 50-pip gain, how is that cause for celebration?

How Forex Trading Works

This happens because forex traders place their trades on buying and selling pips in lots. A standard lot is equal to $100,000 so you can see how a 50-pip gain would be some cause for a little excitement.

That then brings up the question, is forex trading only for those who have $100,000 and above to invest? And if not, how does the average guy get to invest in the forex market?

First, many brokers offer currency trading online in mini-lots. You can purchase currency in mini lots worth $10,000 and trade comfortably and profitably.

But $10k is still too much for most people and that’s where leverage comes in. Many brokers today will offer high leverage levels to their traders.

What Is Leverage

To better explain what leverage is, let me use a practical illustration. Let’s say you want to invest in the highly profitable fx market but you don’t have much capital to start with.

So you can spare a maximum of only about $200. First, you open a mini account with your $200. To begin trading, you purchase a mini lot worth $10,000. What happens is that the trader can provide you with $100 for each dollar you deposit.

So to buy a $10,000 mini lot, all you will spend is $100. In effect, this means the broker has provided you with a 100:1 leverage. In such a scenario, your deposit, which is also referred to as the margin, will be $100.

Forex brokers are known to provide leverage levels of even up to 500:1, which means you can invest in a standard lot worth $100,000 by depositing only $2000.

Using the table below, you can see how leverage can increase your investment levels by depositing only $100.

Table 1: Effects of Leverage on a $100 investment

Advantages of Leverage in Forex

Most other financial markets offer leverage of about 10:1 or 15:1 but the forex market is unique in that brokers can offer almost an unlimited amount of leverage.

The most obvious advantage of using leverage in forex trading is that you can control and profit from a relatively large investment with just a little capital of your own.

As you can see from the table above, with only $1K, you can trade in currency worth half a million dollars.

This means you can greatly increase your potential for profits and earn so much more from your investment. In such an example, if the currency you are trading in experiences a 0.2% gain, your initial investment of $1K doubles itself and you now have $2K in your account.

Therefore, when you are correct in your forex trades, leverage pays off big time.

Disadvantages of Forex Leverage

The same thing that makes leverage so great is also the same reason for your potential downfall.

In the example above, a 0.2% shift in the currency price in a direction opposite to what you had traded on means your entire account has been wiped out in a single trade.

This is the one thing that most forex traders seem to forget when trading.

How Much Is Too Much

No matter how good you are, no one can ever have a perfect currency trading online system that makes profits 100% of the time.

You will have losses once in a while, perhaps even as regularly as you will be making profits. Apart from just suffering one loss at a time, you will occasionally go through losing streaks that may last so many consecutive trades.

Therefore, to make sure you live to trade another day, you should be modest in how much leverage you use.

Margin Call

What most brokers do is they protect themselves against loss by only offering leverage that can be recovered from your trading account in case you suffer losses.

That means that whenever the broker sees that your leverage exposes you to losses that exceed the total amount deposited in your forex trading account, the broker will send you a margin call.

A margin call is simply a warning by a forex broker to a forex trader to increase their margin levels to qualify for the requested leverage amount.

The trader can heed this margin call by either reducing the amount of requested leverage or increase their margin amount.

A margin call simply protects you from taking losses that exceed your total deposit, but it does not protect you from completely wiping out your trade account.

To protect yourself, you have to use money management and risk management techniques. For instance, you can divide your total account investment into ten equal parts and only risk the total wipe-out of one part.

That means even at the highest leverage level available, your total risk will only be 10% of your total account. This allows you to comfortably profit from price trends without bankrupting yourself.

Another technique you can use is not risking more than a set percentage of your account. This site, www.forextradingbig.com, has lots of resources to assist you learn how to avoid risking too much capital when trading.

Though there is no consensus in trading circles, most traders agree that any leverage that has the potential to wipe out 30% or more of your account is too much leverage.

Personally, I am more reserved and I put the figure at 10% though there are more adventurous traders who will routinely accept leverages that can potentially wipe out up to 50% of their total forex trading account.

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