Understanding forex leverage is very important for you because you will be using it a lot in your forex trading. Forex leverage works like the ordinary leverage. Just like in ordinary life when you use a lever, it multiplies your power with a multiple depending on the lever fulcrum, in the same manner forex leverage multiplies your deposit with a certain multiple.
So let’s discuss what is forex leverage as you will find forex accounts allow you to use leverage as high as 500:1. You cannot use this high level of leverage in any other market. For example, in the stock market max leverage that you are allowed is 2:1 whereas in the futures market the maximum leverage allowed is 15:1. So how come forex brokers allow you to use a leverage as high as 500:1.The main reason for that is currency rates change by less than 1% on an intraday basis most of the time. So in order to profit from the fluctuations in the forex rates, you need leverage.
Let’s us explain this in more detail. Currency rate fluctuations are measured in pips. This is the smallest change in the currency rate measured as the change in the fourth decimal place in the price for most currency pairs and measured as the change in the second decimal place for currency pairs involving JPY. For example, suppose, EUR/USD rate changes from 1.3421 to 1.3431. It means the rate has changed by 10 pips. So if you had bought EUR/USD at 1.3421 and sold it at 1.3431, you would have made 10 pips. How much did you make? Suppose you had bought 1 Euro and later on sold this 1 Euro. 1 Euro bought converts into 1.3421 USD and when you sold this 1 Euro, it converted into 1.3431. So in terms of the net gain made in USD, you made a profit of 0.0010 USD.
Now, suppose you had bought 100,000 units of Euro instead. You would have made a profit of $100 if you had made the above transaction. As you can see by using a bigger amount, you had magnified your profit. Precisely because of this reason, you need to trade the currencies in huge amounts in order to profit from the exchange rate fluctuations.
In order to use leverage, forex brokers allow you to open a margin account. Standard trading is done with 100,000 units of the base currency. For example if you are trading EUR/USD, the base currency is EUR and the quote currency is USD. You will buy 100,000 units of EUR or sell 100,000 units of EUR. Now, on a standard account that uses a leverage of 100:1, you can trade 100,000 units of the base currency with a $1,000 deposit.
On the basis of this $1,000 deposit, a broker will let you invest 100,000 in the base currency.This is also known as the margin. This is the amount, the broker keeps as a guarantee in case of you losing in the forex market. With a margin of $1,000 and trading a standard lot, you can only lose 10 pips. After that the broker will close all the open trades automatically as you don’t have sufficient margin capital left in your account to continue trading more.
In essence, you are borrowing money from the broker. So, leverage is a form of a loan that you have to pay later. If you keep it overnight, you will have to pay interest on it as well. Since, most currency market positions are opened or closed in one day or max two to three days, you pay a small amount as an interest on the loan borrowed from the broker. The margin percentage usually is either 1% or 2% of the amount borrowed and depends on the broker.
For 200:1 leverage, the margin required by the broker will be 0.5%.So with a deposit of you will need $1000, you will be able to borrow $200,000 from the broker. In the same manner, for 400:1 leverage, the margin required will be 0.25% and with $1,000, you will be able to borrow $400,000 from the broker for trading.
Now, you might be thinking isn’t it dangerous to use this high level of leverage. Yes, it is! Always keep this in mind that leverage is a double edged sword. If you win, your profit gets amplified and if you lose your losses get amplified. So, it is always a prudent risk and money management rule that you should never risk more than 2% of your capital on a single trade. Learn to slowly grow your capital. Don’t take more than 2% risk per trade. With this risk level, you will be able to take a number of losses in a row and still survive.