Leverage is a blanket term that describes debt that a person or business uses to increase their exposure to a market. Banks leverage their deposits to gain extra income, and many companies use debt to expand the amount of activity that is possible in a given time frame.
A company may use debt to fund the acquisition of a smaller company which is experiencing a growth phase. The amount of money the larger company has to pay on the debt is likely to be much smaller than the revenue growth from the company they are buying, so taking on the leverage makes a lot of sense.
Many traders and speculators also use leverage to amplify the potential gains from a given investment. By using more money than is deposited in a margin account, a small move in the markets will produce larger moves in the underlying account.
What Is Leverage in Forex?
Almost every Forex trader uses leverage when they trade in the global currency markets. Using leverage in the Forex markets simply means that a trader uses borrowed money to make Forex trades so that smaller moves in the markets create meaningful profits.
Using leverage in the Forex markets is the same as using leverage in any other market. There are risks involved in using leverage, which are discussed below.
How Does Forex Leverage Work?
Let’s say that a trader has $5,000 in their Forex brokerage account, and they want to take on a $100,000 position in the EURUSD cross. The trader will need to use $95,000 in borrowed assets, which would give them a leverage ratio of 20:1.
Leverage is easy to calculate. Just take the size of the position, and divide it by the amount of money in a margin account. In the above example, the amount of money backing up the $100,000 position is 1/20th the amount of the position, which can also be expressed as leverage of 20:1.
The margin balance is used to secure the position from a broker, and the trade is placed. If the market goes in the right direction for the trader, their profits will be 20 times higher than if they were trading with no leverage.
How to Use Leverage in Forex Trading
Leverage is almost always used by Forex traders because the amount of movement in major currency pairs is generally very small. By using borrowed money smaller market movements become much larger.
When the Euro falls by 0.05% against the US Dollar, an unleveraged position would barely change in value. If the trader is using leverage of 10:1 that 0.05% move is now worth 0.5%. If leverage of 100:1 is used, it becomes a 5% movement.
Choosing the right level of risk for a Forex trade is critical to maintaining a brokerage account, and making sure that the value of a position isn’t too large for the underlying margin. Failure to understand the risks that are involved in leverages positions can lead to big losses in the space of a single trading day.
Using leverage means that both gains and losses are magnified.
For example, in the example we used above, a move of just 1% in the wrong direction would mean that the trader would lose 20% of their margin balance. When a trader uses leverage, it is very important to calculate stop-loss levels with extreme precision.
Knowing how to use stop-loss orders can help a trader to limit the amount of risk that is inherent to using leverage. Leveraged positions should never be opened without a stop-loss order in place, and the level of the stop-loss order should maintain a positive margin balance.
FXOpen Broker Offers Great Trading Tools
FXOpen Broker gives its clients the ability to use as much as 500:1 leverage with some of the best Forex account options available.
Aspiring traders can open a Micro account at FXOpen Broker with as little as $1, and immediately gain access to leverage as high as 500:1. It also has great account options for more experienced traders. An ECN account with FXOpen Broker can be opened with $100, and gives traders access to more than 70 currency pairs, in addition to CFD trading.
Using leverage is always going to carry risk, so FXOpen Broker gives its clients the industry-standard MT4 and MT5 trading platforms to manage buy and sell levels with some of the best trading platforms ever created.
FXOpen Broker was founded as an educational platform for traders, and it maintains its dedication to helping clients become the best traders possible. If you want to learn more about the educational resources that FXOpen Broker offers, please click here!