Question:
How does leverage minimize foreign exchange risk?
Forex Leverage And Risk
Leverage allows you to trade with more buying power than your deposit provides. This can work for you, as well as against you. Please remember the principal rule of financial management: greater profits and higher risks are intrinsically correlated. Just the same, high leverage is associated with significant risks. When leverage is 100:1, every dollar on your deposit allows you to purchase up to 100 units of another currency. For example, with a deposit of $1,000, you may purchase 100,000 EUR/USD, or 100,000 GBP/USD or 100,000 AUD/USD.
Leverage is a ratio of Trade Size/Deposit. This means that by controlling this ratio you can control your leverage and hence risk exposure. For example, if you have $1,000 on your deposit and you purchase 100,000 units of another currency, your leverage is 100:1 (100,000/1,000=100), but if you purchase 30,000 units of another currency your leverage is 30:1 (30,000/1,000).
If you purchase 1,000 units your leverage is 1:1 (1,000/1,000=1).
If you come from a stock/bonds background, you are probably thinking that a 100:1 leverage ratio is an enormous risk. It is, but leverage is also a risk control factor. First off, remember that in forex trading, the value of a single monetary unit fluctuates less than 2 percent on a daily basis, unlike the extreme point fluctuations that occur in the stock/bonds markets. Leverage does amplify loss, but it also amplifies gains. The risk of leverage is usually minimized by stop-loss and time-price limits.
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