Understanding Leverage in Forex Trading

Investors and traders frequently use the word “Leverage” when they trade in foreign currency. Leverage actually refers to the technique or strategy of increasing the returns on investment (ROI). This definition might seem obscure and difficult to understand for someone who has never done trading in Forex market. If you are new to currency trading, then this article will explain you everything that you need to know about leverage, like its overall relevance and how it works.
What is Leverage?
If you take a dictionary and look for its meaning, leverage will be defined as “using the borrowed funds in order to increase the overall rate of return on a given investment”. This gives the investor complete control of a huge investment in Forex market by allowing them to trade in more than the amount so available in deposit account. This in turn multiples the overall loss and profit potential in a given trade.
How Leverage Works in Forex Trading?
Before you get to know how the Leverage works, you need to have a basic idea on the overall working of the Forex trading system. Forex is actually a big financial hub where different traders keep on speculating relative value of 2 different trading currencies. There are many different currency pairs for e.g. USD/EUR. In this kind of pair, the first currency is called Base and the latter one is known as Quote currency.

If you want to begin trading in the Forex, you need to open a marginal account with the help of any available broker. You can invest in quote currency more than what is actually available in your account. Here the broker comes in and will handle your account by giving you the extra currency in the form of loan so as to begin trading. However the broker will lend the money on certain conditions. The funds that you borrow will be expressed in a certain kind of ratio, say 15:1. Here 15 stands for the loan proportion and 1 is the proportion so invested by you. 15 becomes the leverage amount in this regard. No interest of any kind is charged on the overall margin.

You should know that leverage is being given in a certain fixed amount and the amount varies from one broker to another. Each broker follows a different set of rules which is different from the others available in the market. Typical amounts could be in the proportion of 400:1, 200:1, 100:1 or 50:1. What does the ration imply over here? Consider the leverage amount of 50:1. If you have $100 in your account, then you can opt for an investment not more than $5000 ($50 x $100).

Significance of Leverage in Forex Business

Leverage is nothing but a characteristic feature that can set the Forex trading above from different kinds of financial investments. Profits on a given investment are multiplied with respect to the capital so invested. But leverage can act as a double edged sword at times. Too much of leverage at times can multiple the losses and you will end up nowhere in the Forex market as a trader. Since Forex is a highly volatile market, you need to use a sound strategy so as to protect the profits and minimize the overall losses.

From STEVE GARDNER