What is Leverage in Forex?
Leverage refers to the facility provided by forex brokers to allow you to trade with more money than what's actually in your account. It's like a loan, and you are required to put up a deposit of your own funds to secure it.
It is commonly known as the "double edged sword" in forex trading. It can be as high as 1000:1 but generally is around the 100:1 to 500:1 range. Some countries by law may impose ever lower leverage ratios.
At a leverage of 100:1, if you had an account balance of just $1,000 you can trade $100,000 worth of currency. Why would anyone loan you, in this case $99,000?
The answer lies in the way currencies change in value. If you look at any stock on the NASDAQ, they quote prices to 2 decimal places. Currencies however work on the 4th decimal place. Furthermore, currencies don't change in value so quickly or drastically.
For example, a stock valued at $1 could double, triple or increase even more in value (think pharmaceuticals or mining companies) but $1 US Dollar which is worth $1.3736 Canadian Dollars (at the time of writing, May 11th, 2017) isn't going to all of a sudden be worth $2 Canadian Dollars.
Let's look at it in more detail so you can see the difference and understand why leverage is neccessary to attract new traders:
|Type||Investment||Price||Value||After 3 mths||Value||Profit|
|Forex USD/CAD*||$1,000||$1.3736||$1,373.60||$1.3986||$1,398.60||$25 CAD (~2%)|
Is it worth investing your $1,000 in the second example where after 3 months, you profit just $25 Canadian dollars? Not really. If you invested $100,000 then it would be worth it because you would have 100 times the profit, $2,500 CAD. But not everyone has $100,000 of their own money to put into a trading account. And here, is where leverage helps in the forex market.
With a 100:1 leverage as mentioned earlier, you can buy $100,000 worth of USD/CAD by depositing just $1,000.
But what if the currency value goes down? How much could you lose?
Suppose that the value went down by the same amount as the example above. Will you lose $2,500 if you bought $100,000 worth using the 100:1 leverage? It's more than the $1,000 you deposited!
No decent broker is going to let you get to that stage, the main reason being that they have just let you "borrow" $99,000 without any credit checks! There's no way they will let you lose their money, and this is where a mechanism called a "margin call" comes into play. Read on to learn about a margin call and how it works to protect both you and the broker.
*Simplified example. In forex, you buy or sell a "currency pair" depending on which way you think the price will move. Profit or loss is finalised when closing the trade, meaning if you bought, then you sell. If you sold, then you buy.