Back to: Introduction to Forex
Leverage is borrowing money from the forex broker so that you can get an even bigger exposure to the markets, you don’t pay any interest on the loan, so in forex trading, a small amount of deposit can control a much larger total contract value. Leverage gives a trader the ability to make nice profits, and to keep risk capital to a minimum. With $100 you can handle currency that’s worth $1000, e.g. if you make 2% from the $1000 that means that you have made $20 and your trading account is $120 now.
Size of leverage:(50:1) (100:1) (200:1) (500; 1) (1000:1)
For example, a forex broker may offer 50-to-1 leverage, which means that a $50 margin deposit would enable a trader to buy or sell $2,500 worth of currencies. Similarly, with $500 dollars, one could trade with $25,000 dollars and so on. While this is all gravy, let’s remember that leverage is a double-edged sword. Without proper risk management, this high degree of leverage can lead to large losses as well as gains. You are probably wondering how a small investor like yourself can trade such large amounts of money. Think of your broker as a bank who basically fronts you $100,000 to buy currencies. All the bank asks from you is that you give it $1,000 as a good faith deposit, which he will hold for you but not necessarily keep. Sounds too good to be true? This is how forex trading using leverage works.
The amount of leverage you use will depend on your broker and what you feel comfortable with.
Typically, the broker will require a trade deposit, also known as “account margin” or “initial margin.” Once you have deposited your money you will then be able to trade. The broker will also specify how much they require per position (lot) traded.
For example, if the allowed leverage is 100:1 (or 1% of position required), and you wanted to trade a position worth $100,000, but you only have $5,000 in your account. No problem as your broker would set aside $1,000 as down payment, or the “margin,” and let you “borrow” the rest. Of course, any losses or gains will be deducted or added to the remaining cash balance in your account.
The minimum security (margin) for each lot will vary from broker to broker. In the example above, the broker required a one percent margin. This means that for every $100,000 traded, the broker wants $1,000 as a deposit on the position.