Leverage

What changes the whole picture, and turns the Forex market into a market of opportunities to profit a lot of money in a short span of time, is leverage. But…of course, leverage causes trading to become more risky.

So what is leverage?

Brokers allow you to perform transactions in sums of money which are much larger than the amounts that you have in your account. Sometimes even up to 400 times more than what you have invested.

For example: You have deposited 1000 USD, the exchange rate of the Euro against the USD is 1.5220. And you believe that the price of the Euro is about to rise by 100 pips. That is your opinion.

You can pick up the phone and call the broker or give an order via the computer, 24 hours a day “please buy me 100,000 Euros”

Despite the fact that you have deposited 1000 USD and 100,000 Euros cost 152,000 USD, in this case you have taken advantage of a leverage of 152 times the money which you have in your account.

In a transaction of 100,000 Euros, how much is each pip worth. We learned it already, remember? 10 USD. Let's assume that the exchange rate indeed rose to 1.5320. How many pips have you earned? 100. And how much money have you earned? 100*10 = 1000 USD.

Let's deduct the commission, and the net profit from the transaction will be 970 USD. Nearly a 100% return in one day.

How great!

But…what will happen if the exchange rate falls to 1.5120?

You have lost 100 pips, you have lost all of your 1000 USD.


The Multiplier Effect of Leverage in Forex

Think of forex leverage as a multiplier. The smallest changes in the prices of currency prices would be magnified when applied to your trading account. The usual forex leverage for forex accounts nowadays is a 1:100 leverage. This simply means that for any single dollar that an investors puts out for trade, his forex broker multiplies that amount by 100. And that multiplied amount becomes the basis for any changes in the currency price of the investor’s traded pair.

It is like being able to borrow money which is 100 times the amount of what you put out. Comparing it to a mortgage, it’s like being able to buy a house with only a 1% downpayment, and the rest is taken care of by your bank. Should the house appreciate in value, and you decide to sell it, you get the whole profit from the sale. Of course, after the sale you would have to pay back the amount that you loaned from the bank with interest charges, depending on how long you hold on to the property using the loaned amount.

In the example above, it is very much possible that your profit is greater than the amount that you initially put out. The same is true with forex trading. The profit that you can gain for any single forex trade can be greater than the actual money that you exposed for that trade position.

But, on the other side of the coin, any forex trader should be prepared for the possibility that a trade can go against his position – meaning, a loss is always possible as no one really knows how the forex markets would move.

So, using the same explanation, it is also very much possible that a forex investors loss, should the market go against his trade position, is greater than the amount that the investor exposed in his trade. Since the traded equity is multiplied 100 times (or whatever the forex leverage is with his forex broker), the profits or losses, just the same, are also multiplied 100 times.

That is where forex leverage becomes a double-edged sword. It is a double-edged sword because it can help you conquer the forex markets and profit from it. Or it can also be destructive for a forex investor with wrong positions taken with his trades, and slice down his account into smaller pieces.


Use Forex Leverage to Your Advantage

Knowing that forex leverage is a double-edged sword, proper safeguards must be observed by forex investors to tame the effects of forex leverage. And this can be done with proper capital management and strict trading discipline.

Knowing that forex leverage shall multiply the amount of equity he exposes, a wise forex investor should always compute according to this multiplied value in mind, and how price changes would affect the totality of his equity. Being conservative with the management of risks can protect a forex trader from unnecessary losses.

Although forex leverage is a double-edged sword it does not mean that it shall always be harmful for the forex investor. In the first place, it is forex leverage which lured many forex traders into investing in currency trading in the first place. Just know how to use forex leverage to your advantage, and always compute how much effect forex leverage can have into your trading account to prevent massive losses which can excessively reduce your account equity. Control forex leverage with proper capital management and you will be on your way to a correctly managed forex investment.


Should you leverage?

Later on you will learn whether it is worthwhile to leverage your transactions and by how much. But one must always remember, for whoever wants to leverage – the option is always available, but it's risky.

When there is a leverage of 300 times you can perform a transaction of 300,000 Euros as well, and if the price rose by 100 pips, you can even earn a 300% return in one day. But if the exchange rate decreases by 33 pips, you have lost your whole investment.

Why do the firms allow us to leverage?

The answer is simple: It is preferable for them that we perform a transaction of one million Euros rather than a transaction of 10,000 Euros, in this way the broker earns a commission of 300 USD and not 3 USD.

Later on you will learn what your interest is as traders, and why you shouldn't be tempted to leverage transactions.