In investing, leverage is used to increase the amount that can be returned on the investment. With foreign currency exchange (Forex) trading, leverage occurs when the trader borrows moneys from a broker and uses the funds for the specific purpose of Forex trading.
Thanks to the leverage system of Forex trading, traders can make small investments but still have access to large amounts of funds. It is typical for a Forex broker to offer 1 to 100 ratios for contracts. Under this situation, an investment of $1000 would be worth $100,000. Compared to other investments, this is a very high amount. It is even common to find leverage as high as 1 to 200, though this is usually for amounts of under $50,000. With equities, for example, traders must have at least half of the monetary value of trades. Thus, Forex trading becomes profitable while still minimizing risk.
Because the leverage of Forex trading is so high, it is also high risk. With equities, for example, the leverage is usually 1 to 2. With futures, the leverage is usually 1 to 15. However, Forex trading is not so risky once you consider that most foreign currencies don’t change by more than 1% daily. Unless there is a massive collapse of a currency, it is unlikely that you will experience a huge loss. On the other hand, equity and future trades can easily change by 10% daily.
Forex brokers will usually have a minimum amount requirement, known as the initial margin. When you deposit this amount, then you will be allowed to start Forex trading through the broker. The Forex broker will also determine the amount which is required per position (called a “lot”) which gets traded. For example, if you have an initial margin of $2,000, you may be able to trade 2 lots of $100,000, or $200,000 total. Because the amount of the lot is so much greater than the initial margin, Forex traders have the benefit of controlling large amounts of money with little risk but still the change to have large rates of return.
Here is an example of how leverage margins can work in your advantage with Forex trading:
You have an initial investment of $2000 in a 1: 100 margin account, so you are given the purchasing powers of $200,000. You use this purchasing power for a trade of EUR/USD at USD/CAD 1.0210 (which means you buy 1.0210 Canadian dollars for each 1 US dollar) and sell at the price of 1.0201.
Since you have such as high margin, you are in control of CA$204,200. With the sell price of 1.0201, you calculate (204,200/1.0201) and get $200,176, which is profit of $176. The rate of return on your investment is calculated (176/2000×100%) and is 8.8%.
Understanding Leverage in Forex TradingCompared to other markets, the high leverage of Forex trading allows you to get a much higher rate of return on your investment. If you took this same example above but without the 1: 100 leverage, you would only have the purchasing power of CA$2,042 and get a return of (2,042/1.0201) US$2,001.76, a profit of just $1.76. This rate of return is only 0.088%.