The Forex market is a dynamic and fast moving place. It’s not really a centralized market, like you would find with the New York Stock Exchange. Thanks to the internet, the Forex market is more of a decentralized set of brokers that buy and sell currencies. It also happens to be the largest marketplace in the world, with $1 trillion or more being traded on a daily basis. However, for a trader to do well in the Forex marketplace, a serious understanding of how currencies are traded and how to overcome things like the spread and leverage.
Beating the Spread
The spread is the difference between the ask and the bid prices of a currency pair. Usually, it is just a few pips difference, but this is something that can make or break you as a trader. If you believe that the EUR/USD pair is going to rise in price, you would buy the asset at the ask price. Let’s say that it is currently 1.1103. If you wanted to immediately sell the pair, then the bid price would put you at an immediate loss as the bid is always lower than the ask. If you had a really good broker, the bid would stand at something like 1.1100.
In this light, it only makes sense to purchase a pair unless you expect more than enough movement to beat the spread. If the asset moves, but not enough to beat the spread, you’ve still lost money. Being able to predict change is a good start at being a good Forex trader, but being able to predict momentum and magnitude will make you a great Forex trader.
The other half of being able to trade well within the Forex market is knowing how to use leverage. For a lot of people, leverage looks like free money. In a way, it kind of is. But the ability to recognize leverage for what it really is will take your trading to the next level. Leverage is basically a line of credit that a broker lets you use as you execute your trades. Some brokers will let you go up as high as 400 times the amount that you are trading. If you wanted to risk $1 of your own, your broker would let you have $400 worth of buying power. This can be a great gift when you are correct in your trades and everything is moving the way that you want it to. But as you might have guessed, if you’re incorrect, then the losses come out of your account. Let’s say you want to trade $10 with a 400x leverage force behind it for a total risk of $4,000. Now, let’s say that the pair dropped 1 percent before you closed the position. Instead of losing $0.10 like you would have with the $10 you risked, you actually lost $40.
Leverage is a two-way street, and inexperienced traders are usually on the wrong side of it. What’s even worse than this is an experienced trader that has just been really lucky so that they are not using leverage with the caution that it deserves.
So how do you best use it? For one, you need to be able to identify situations where you have a better chance of success than others. You shouldn’t ever open up a position if you don’t have a very strong chance of success, but when the odds of success are higher than normal, using more leverage than normal can be helpful for increasing profits at a faster rate. Also, you should never use a high amount of risk in comparison to your account size. So, if you have $10,000 in your account, risking $10 with 100x leverage is putting 10 percent of your account into play at once. In most cases, this would be far too much and should be avoided.