Understanding Leverage

Forex is a speculative market where currencies are traded and as with all speculative markets you really need to understand the concept of leverage.  The ratio of investment to actual value is that is referred to as “leverage” and this is a central concept to making money when trading forex online.  Collateral for the loan/leverage in your forex trading account is provided by the original deposit.

For example if you use $1,000 of your own money to buy a forex contract worth $100,000 you are leveraging your original investment at a 100:1 ratio.  The $1,000 is all you risk, however the gains you can make may be far greater than this.

Leverage allows you to use only a small amount of your money to initiate a high-value forex contract.  This raises the stakes because the smallest movement can magnify gains/losses.  Leverage is the key to trading forex because without it you would need to invest vast sums of money which many do not have access to.

Example of Leveraging in the Forex Trading market

Lets say you have done your research and strongly believe that the AUD is going to rise against the USD.  You take out a position to buy AUD/USD at $1.0213 and over the next hour it climbs to 1.0223, increasing one-tenth of a cent or 10 pips (refer to what is a pip to understand further).  This is a tiny movement in the scheme of things but each PIP to you due to leveraging maybe worth $10.  Therefore the $100 just made on 10 pips would have required an investment of $100,000 without the use of leveraging.

Brokers and Leveraging

Forex Brokers will typically provide from 50:1 to 500:1 leverage maximum.  A 100:1 trade means that you only need to provide $1,000 of your own funds to access a $100,000 forex contract.  If the market moves in your favor you can easily return 10% in a matter of hours.  However keep in mind the use of leverage can incur big losses if the market does not go your way.  If you for example took out a small trade of $200 in a 100:1 trade worth $20,000 and the currency pair you are trading on falls drastically on adverse news some one and a half cents then you could totally wipe out your original trade.

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