At the most basic level, leverage refers to something that you can use to attain a greater effect. It comes from the word “lever.” In forex trading, leverage refers to the ability to control a large amount of trading capital while having a small amount of money on your trading account.
Forex brokers offer leverage to trade. Anyone with a trading account can access that leverage should they need it. To view the full range of different leveraged account types Accuindex offers, visit our Accounts Page.
Why leverage to trade is necessary sometimes
Under normal circumstances, stable currency pairs, such as USD/CHF and USD/GBP only make minimal price movements during typical trading days.
If traders were only using the money they have on their accounts to execute trades, it would not be too significant to see even a 10% gain on the trading account after a year of trading.
However, leverage “spices” things up and allows traders to make significant gains from even the smallest of market movements. For example, it is possible for a trader to register a gain of 10% in one day if they harness the power of leverage.
However, be aware that leverage has been aptly described as a two-way street, or as it is most commonly known, a double-edged sword. Just as you can make gains by using leverage, you can also make massive losses if things do not go your way while you are using leverage to trade.
Common levels of leverage to trade with
Different brokers normally avail different levels of leverage to trade with, depending on the specific regulations or rules of each broker. The leverage levels are normally indicated as ratios, and we explore the most common ones below.
50:1 leverage level
This means that for each single dollar in your trading account, you have the liberty to enter a trade which has a total value that reaches a maximum of $50. For example, if you choose to deposit $100 in your trading account, you are free to enter trades that have a worth which totals up to $5,000. If you deposit $500, you are eligible for trades worth a combined total of $25,000!
100:1 leverage level
This leverage ratio means that for each dollar on your trading account, you have the liberty to enter a trade or trades worth up to a maximum of $100. This level of leverage is normally given with standard lot trading accounts whose minimum deposit is $2,000. For example, if you have $2,000 on your trading account, you are at liberty to enter trades worth up to $200,000.
200:1 leverage level
With a dollar on your account and 200:1 leverage to trade with, you will be in a position to control trades worth a maximum of $200. This level of leverage is frequently permitted for traders who own mini lot trading accounts. The minimum deposit on such accounts is normally about $300, so such a level of leverage allows the traders to push their limited capital to get as much from it as possible while trading. For example, a trader with $300 on their account can access trades to the value of $60,000.
400:1 leverage level
Some forex brokers go as far as offering 400:1 leverage to those trading with them. This is high leverage because each dollar on your trading account allows you to enter trades worth a maximum of $400. This means that if you have $500 on your account, you are free to execute trades worth up to $200,000! Such leverage is often not given to people trading using mini accounts as all their capital can be wiped out in the blink of an eye if the trade goes against what they had hoped for. If you go for this level of leverage it’s important you understand the risks and potential rewards.
Where does the rest of the money come from when trading with leverage?
The forex broker usually lends money to traders to allow them to enter bigger trades than their capital would typically allow them to.
Think of the common example of buying a home. If you are required to deposit 20% of the purchase price of the home, the rest of the money will be lent to you by your bank, and the bank will use the home as collateral for that loan.
In a similar way, the forex broker will loan you money based on the leverage level permitted. For example, if you are using 50:1 leverage, the broker will reserve $1 from your trading account and give you a loan of $49. That loan will be paid back – sometimes with interest – at the prevailing interest rate for the currency you are trading.
What is a margin?
A margin is the amount a forex broker sets aside from your account balance in order to back the trade that you would like to make. In the 50:1 ratio above, the margin would be a dollar, so that you are free to command $50 in trading capital. The higher the margin requirement, the lower the leverage available to you.
If trades go against you and your available account balance goes below what is needed as a margin, you will get the dreaded “margin call”. When this happens, some or all of your open trades will be closed to protect your broker from making losses on your behalf.
Summing it up…
While leverage is a tempting force multiplier, experienced professional traders stick to lower levels of leverage in order to minimize their potential losses while protecting any gains that they make. It is advisable to be as conservative as you can while using leverage, and then choose carefully when to opt for higher levels of leverage. Remember, leverage is a double-edged sword, and you don’t want to be casual in the way you handle such a fickle tool!
High Risk Investment Warning: Trading foreign exchange on margin carries a high level of risk, and may not be suitable for all investors. The high degree of leverage can work against you as well as for you. Before deciding to trade foreign exchange you should carefully consider your investment objectives, level of experience, and risk appetite. The possibility exists that you could sustain a loss of some or all of your initial investment and therefore you should not invest money that you cannot afford to lose. You should be aware of all the risks associated with foreign exchange trading, and seek advice from an independent financial adviser if you have any doubts.