One aspect that makes forex so popular is its affordable and variable capital cost. Thanks to leverage, an investor can participate in trades worth thousands dollars with a much smaller deposit. But not every trader understands the term “leverage” clearly. This article will help you learn more.
A forex trader usually must deposit an amount of money, called margin, to open a position with a broker. Leverage is a tool that takes this deposit and combines it with others, into a bigger one called “super margin deposit”.
There are many traders participating in the forex market, and the broker combines their margins, so an individual trader can then conversely borrow from the broker, which is leverage. In effect, with leverage a trader can control a larger amount of money than their actual deposit.
Why is leverage needed?
Profit in forex comes from the change in the rate of currency pairs. For example, a trader buys EUR/USD at 1.2500 with his $1,000; the rate then grows to 1.2550 or moves 50 pips. In this case, for each Euro he buys, he earns $0.005 or 0.5 cents. The total profit in USD is:
$4 is an insignificant income comparing to $1,000 of capital. Here’s another example with the same currency pair and price movement – but this time, the trader buys a standard lot of $100,000. The profit in USD is now:
What can be learned from this example is that only a sizable investment can bring a significant return, such as $100,000 or more. But most of us cannot afford a big deposit like this, and that’s why we need to borrow from the broker, using leverage.
Margin and Leverage
These two terms always go together. Normally, margin is calculated by the percentage of total transaction value and leverage is the corresponding ratio.
For example, if the required margin is 1%, and you intend to buy a standard lot costing $100,000, then the margin you must deposit is $1,000; corresponding with it, the leverage or the ratio is 1:100. Now, you can control $100,000 with your $1,000.
Similarly, with the other required margin of 10%, 2%, 0.5%, 0.01%, there are respective leverage ratios such as 1:10, 1:50, 1:200, 1:1000 and others.
Is Leverage A Double-edged Sword?
A high return always comes with high risk. In the example we have discussed above, a trader buys a standard lot of EUR/USD at the rate of 1.2500. The change of rate is monitored by pip – the fourth decimal places in rate – each of which costs:
$100,000 x 0.0001 = $10
In a positive scenario, the rate goes 50 pips higher, and that trader earns $400. But in the reverse negative scenario, an unlucky trader could lose $400 if the price moves 50 pips lower, which is a big number in comparison with the original investment.
Therefore higher leverage can magnify the return significantly, but it also increases the possible risk. To prevent a losing trade from becoming worse, traders must use a tool called stop loss, which will quit your trade when it hits a specified level, if the price moves against you.
The Bottom Line
In summary, the main aspects of leverage are:
- A tool to increase your possible return
- Always corresponds with required margin
- Higher leverage can bring a higher risk
Leverage is the key that makes forex trading affordable. You don’t need to be rich to participate in forex because with leverage you can control bigger money than your deposit. However, always keep in mind that high leverage can lead to disaster if you are careless. Above all, practice makes perfect, so if you’re unsure in the beginning, use a demo account until you’re comfortable trading with leverage for real.