How Does Leverage Work in the Forex Market?

What is Leverage?

Leverage describes the concept of borrowing money from a broker to increase the amount of purchase power in a Forex transaction (Investopedia, 2011). For instance, a high leverage amount would be 200:1. For every $1 invested, the amount will be matched by $200. Therefore, if the investor invests $1000, they may have access to $200,000 purchase power through leverage and margin trading.

Some brokers may require 1% or more of the total transaction to obtain the leverage that is required to invest for a pair. If the total amount is $100,000, then the margin required will be US $1,000. The margin based leverage may be equal to 100:1 or 100,000:1,000. Leverage is simply the amount they broker will allow you to borrow based upon initial investment.

How are Leverage and Margin Interconnected?

Margin is used to create leverage in Forex trading. Leverage simply describes the process of taking the amount borrowed or debt to invest for a larger profit. Most often leverage is expressed in terms of a ratio or a margin percentage. Mathematically, leverage may be represented as 100/ margin percentage, where margin percentage is expressed as 100/leverage.

Why Do Investors Prefer Leverage Trading

High leverage capacities are the primary reasons why investors are attracted to leverage trading. The potential to earn more profit with a small investment is greater. When brokers provide collateral or leverage, then the investor has the opportunity to increase their profits by the leverage amount. This amount is usually 200 times the amount or less.

Forex provides more leverage than other financial markets, because the volatility of the currencies rarely goes beyond 1% daily (Fintoc, 2011). By contrast, stocks may fluctuate in price 5% to 10% daily. A one cent move in currencies is significant. This may be indicated by 100 pips on a chart. Since volatility is low, leverage is required to achieve high returns or profits. If you only had a few thousand dollars and attempted to trade Forex, the return on investment would not be worth the effort.

Disadvantages of Leverage

While leverage allows you to gain profit faster, leverage can also magnify your losses faster. Therefore, when you begin investing, it is best to start with small increments so you can minimize your losses. As you begin to notice patterns in the market movement, you can increase your leverage and maximize your profits.

Practice accounts are recommended for this reason. They allow you to make mistakes and notice patterns without any risk of real cash investment. Many brokers will offer $50,000 or $100,000 practice accounts to begin the trading process.

Who Uses Leverage?

Most people investing in Forex will use the concept of leverage (Investopedia, 2011). Both individual investors and companies have benefited from capital brokers offer for collateral. Many investors will use a combination of investments to increase their assets. From margin accounts to options, companies use leverage to finance their assets. Companies may also use margin to invest in their businesses and increase shareholder value. This is an alternative to using stock to raise capital for a company.

Conclusion

What investors must recognize is that if the currency market were more volatile, leverage would not be necessary. If currencies were as volatile as stocks, brokers would not offer investors as much leverage. Without leverage smaller investors would never participate, because the investment requirements would be too high to realize a profit. Most people cannot afford or do not have the capital to realize significant profits.

References:

• Leverage and Margin – Trading on Margin. (2011). Retrieved August 18, 2011 from http://www.forex.com/Default.aspx?DN=0f193c08-f1c7-4953-bcd8-58ce946c900e

• Forex Trading Leverage. (2011). Retrieved August 18, 2011 from http://www.pipstory.com/forex-trading-leverage.html.

• How to Prosper at Forex Trading – Leverage and K-Factor (2011). Retrieved August 18, 2011 from http://www.tradingfives.com/articles/how-to-prosper-at-forex-trading—-leverage—the-k-factor.html

• Forex Leverage. (2011). Retrieved August 18, 2011 from http://www.finotec.com/forex/leverage.php

• How Does Leverage Work in the Forex Market? (2009). Retrieved August 18, 2011 from http://www.investopedia.com/ask/answers/06/forexleverage.asp#axzz1VLiJ5shS

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