When you visit a broker’s website, you will see statements like “We offer 200:1 leverage” flashing in bold or strong colours. We have also been mentioning leverage quite a few times in our previous articles. So exactly what is it about this leverage that it is so important. We’ll explain it all in this article.
The Definition of Leverage
Leverage, literally, means ‘boost’. In business or finance terminology, leverage is monetary boost given to you in the form of a loan. In FX trading, you broker gives you a loan with which you can buy more lots, or in other words, control more currencies with little capital of your own.
How Leverage Works in Forex Trading
How it works is, your broker provides you with a loan of say, $100,000 in return of a minimum deposit of certain amount, let’s say, $1000. Thus, the ratio of your capital to borrowed capital is 1:100.
This, essential means that your broker will ‘leverage’ your account by 100; or match each dollar you put in with $100 of his own. The amount that he gives you is called leverage.
So how does this leverage help you? The most obvious answer is that it gives you more capital with which to buy more currency.
Suppose you were trading without the leverage, you would have only $1000 and considering that a micro lot is usually worth $1000; that’s all that you would have to trade with. With leverage, you can now trade $100,000 worth of lots. If your broker offers a 200:1 leverage, that means you would be able to trade $200,000 worth of lots with $1000 of your own capital or $100,000 worth of lots with $500 of your own capital.
Leverage and Profit
However, more than that, the real effect leverage has, is on your profit. Suppose you’re working with 100:1 leverage, and purchasing $100,000 worth of lots. Let’s say this investment rises up to $101,000. Now, because of the leverage, you only had to provide $1000 of your own capital and the rest is borrowed.
So, what is your profit? Profit $1000/Initial capital $1000 = a cool 100% profit. If you had no leverage, you’d have to fund the entire $100,000 on your own, and your profit would be a measly 1% (1000/100,000).
Double Edged Sword
But, there’s a saying in trading circles: “Leverage is a double-edged sword” Thus, those who can’t tread cautiously had better stay off. In the above example, suppose the investment had dropped to $90,000. In that case, you’d have a whopping $1000 loss too.
The trick lies in knowing exactly how leverage can affect your trading; how much of it is good; and how much your own capital should be. Many traders will open $250 accounts relying solely on the leverage provided by their brokers and then wonder why they lost all their money trading FX. It is very important to understand leverage entirely before using it.