What is Leverage?
Leverage is the technique of using a loan in order to increase the size of a trade or investment, which in turn increases the potential risk and reward. Common examples may be a company borrowing money in order to fund investment in a new shop or factory, or a homeowner using a mortgage to finance a property which they hope to sell at a profit.
In foreign exchange markets the rate may only change by a fraction of a penny a day, so in order to boost potential earnings a broker will offer a loan to a trader to multiply the size of their trade allowing bigger gains from a smaller position.
How is Leverage Implemented in Forex?
The use of leverage is a key aspect of Forex trading.
Forex trading contracts are very large, but brokers permit their clients to access small parts of them using leverage.
When an investor first opens up an account with a broker, one of the first options to be chosen is the level of leverage obtained.
Usually, the amount of leverage provided is either 50:1, 100:1 or 200:1, depending on the broker and the size of the position the investor is trading.
Leverage of 200:1 is usually used for positions of $50,000 or less. Many traders have “mini-accounts,” so that, to trade $100,000 of currency, with a margin of 1%, an investor will only have to deposit $1,000 into his or her margin account.
The leverage provided on a trade like this is 100:1. Leverage of this size is significantly larger than the 2:1 leverage commonly provided on equities and the 15:1 leverage provided by the futures market.
This would ordinarily seem terribly risky, but traders are never asked to “cover their margins” in forex trading.
Currency prices usually change by less than 1% in a given day. Should a major shift take place, the broker has an automatic “stop” in place that will prevent your account from losing more than the cash or credit it has in place.
This is why it is difficult to trade forex with less than US$10,000 (or the equivalent) on hand even in a mini-account – a sizable shift in the value of one currency can devour all the money in an account in a matter of seconds.
To avoid such losses, forex traders usually implement a strict trading style that includes the use of stop and limit orders.