Traders new to the world of foreign exchange often don’t understand the very tool that makes their trading possible: Leverage. The concept of leverage is what makes the markets accessible to new traders with little funds!
Leverage in the Forex Markets:
Leverage is like a short-term loan a broker gives a trader to allow more buying power. Laws vary around the world, but in the United States, brokers are allowed to give traders fifty-to-one leverage. This means that whenever a trader puts $1 into an investment, a broker will match it with $49. This leverage is a great advantage afforded to currencies traders, as it can significantly expand a trader’s profit potential.
Let’s take a quick look at how leverage works:
You see indications that the US dollar is going up in comparison to the Japanese Yen. So you want to purchase 1 regular lot, which is going to cost you $100,000. Your broker, however, has given you 100 to 1 leverage. This means that you can borrow $99,000 from your broker as long as you have at least 1% of the lot size in your account.
Since you were buying at a 1% margin, $1000 US dollars are set aside so that you can open up the trade. You now control $100,000 US dollars worth of Japanese Yen. Let’s assume the exchange rate does indeed rise one cent and you close your position. At first glance this might sound like just a slight increase, but that seemingly insignificant climb earned you a cent for every dollar you had leveraged. You made roughly $1,000 US dollars.
We can simplify this idea by thinking about a home loan. I don’t have the money to buy a $200,000 home outright, but I do have $20,000. I can use that $20,000, or 10%, as a down payment, and the mortgage lender will match it with the remaining 90%. Then, if the house’s value has appreciated in five years, I can claim a profit! However, if the house depreciates to $150,000 not only do I have to take the loss, but I still have to pay back my loan.
It is important to keep in mind that amplifying the effect of a price movement with leverage goes both ways; it increases profit potential, but also increases risk (you can see why the Apiary Fund teaches strict risk management). Pair your new understanding of leverage with an understanding of money management when you trade.