What is Leverage?
Leverage is the concept of borrowing money from your Forex broker to boost the outcome of a trade. Leverage is a financial tool that allows you to notably increase the possible profits from a trade. With leverage, you can trade bigger trade sizes than what your account could normally trade.
Leverage is a double-edged sword. On the one hand, it helps us trade bigger sizes and grow faster our account, but on the other hand, it can also amplify your losses and you can go broke on a few bad trades.
Leverage at Work
Here is an example of how we can apply leverage to a Forex transaction. Assume that you have an account balance of $10,000 and your broker offers you the standard 1:100 leverage. A leverage of 1:100 means that you can control $1,000,000 worth of buying power ($10,000 x 100) with only $10,000.
In this example, you decide to only buy $100,000 worth of EUR/USD at a rate of 1.1800. Since our position size is only $100,000, or 10 times more than our account balance, we are ultimately only using an effective leverage of 1:10.
After we bought EUR/USD, the exchange rate moves up to 1.2000 and you decide to close your trade making a 200 pips profit.
The total profit is $2000 (200 pips x $10/pip).
If you have not used leverage, and only used your $10,000 to buy a small EUR/USD position, your total profit after EUR/USD had rallied 200 pips would have only been $200. Your 1:100 leverage has allowed you to earn 10 times more than you would have if you were trading without leverage.
This is the clearest example of how leverage to amplify your returns. Depending on your account type and your risk profile, you can trade smaller or bigger position sizes and use a different level of leverage.
If you want to understand how to properly size your trades you should be familiar with the concept of Margin Trading. Leverage and margin are essentially tied together.
What is Margin Trading?
In Forex trading, if you’re using leverage, you’re not required to have the whole position size of what you’re buying and selling. You only have to deposit enough money to cover possible losses. This deposit is called the Margin.
The margin is the amount of money that your Forex broker will require you to put up in order to open a trade. The broker will lock up the required margin for the period the trade is held, and it will release it back to you once the trade is closed.
For example, if you want to buy 10,000 EUR/USD you can either deposit the whole amount, but with margin trading if you choose a leverage of 1:100 you only have to put up 1/100 of the total amount as margin which will be $100. So with $100 margin, you can trade $10,000.
Leverage is one of the main ways that banks profit in trading currencies, and this leverage is available to retail traders as well. Leverage can turn good trades into great trades. Remember, however, that while leverage can boost your potential profits it can also lead you to bigger potential losses. You need to make sure you employ sound risk management strategies and improve your trading skills to ensure your profitability as a trader.