The term leverage refers to two elements. Firstly, the mechanism for making a much larger than the corresponding to the money, an investor has actually position. Secondly, the expected profitability of a financial product or derivative forward transaction compared to the profitability of transactions underlying only on assets of these products or these futures.
The leverage associated with forex is much higher than that offered on other financial markets such as stock markets or commodity markets.
Currency volatility rarely exceeds the threshold of 1% per day, which is considered on the forex market like a rather significant movement. Leverage allows to make significant changes from relatively small market gains. Moreover, very often, currencies are traded by lot (the amount of a standard lot is 100,000 units of an account for a classic margin).
The use of leverage is almost essential in order to invest and make money in forex. It is necessary that transactions are significant enough to take advantage of the price differences.
What is leverage?
Leverage is offered by brokers in forex in the form of prizes. It provides the possibility to position a total of $ 100,000 with a deposit equivalent to a $1,000 account. This is called leverage.
Different leverage levels are available from broker to broker. The effect of leverage allowed may vary depending on the broker from 20 to 400 times the amount deposited into the account of the investor. Each investor has the possibility to choose their leverage in terms of its risk aversion and the yield search.
In turn, the greater the leverage, the higher the importance of the risk involved.
Indeed, each change in pip (point of forex trading) in the opposite direction from the position taken by the investor will result in a loss much greater than the effect of leverage. If prices are moving to the detriment of the position taken by the investor may, a significant loss of funds may occur. The leverage has to be used with extreme caution and in a very reserved manner.
An example of leverage
A customer has 5050 euros on his margin account opened with a broker. It has a leverage of 100. He bought five lots (each lot of 100 000 means to pay 1000 euros) for the EUR/USD rate of 1.3950. The margin used is 5000 euros.
If the market moves in his favor and the exchange rate reaches 1.4050 (which represents an increase of 100 points), his profit is $ 5000 (100 points x $ 10 per point X 5), an increase of 3558 euros (5000/1.4050). The performance is 70% compared to 5050 euros deposited in his account. Of course, the risk is in the event that the exchange rate moves against him. Thus, if the exchange rate reaches 1.3850 (range 100 points down), it shows a loss of 3610 euros (100 points x $ 10 per point X 5 / 1.3850), the traders initial capital can suffer from great losses. If the trader wishes to maintain his position, he will definitely need to invest more funds.
To conclude, leverage is a very powerful tool and can assist in generating huge profits only and if used wisely and of course in moderation. If used without a proper strategy and merely as a tool of greed in an attempt to become suddenly rich, the results can truly be detrimental.