Forex trading has always been one of the most popular types of investment policies. But the thing that makes it so appealing to the investors is the fact that you can obviously get much higher leverage in forex than any other trading option. However, most of the investors do not understand how the leverage works in forex and it sometimes becomes the reason behind their losses. So, without spending much time; let us answer the question ‘’What is Leverage?’’ and ‘’How Does Leverage Work in the Forex Market?’’
Leverage in Forex
Leverage is actually nothing but borrowing some money for investing in some other thing. In forex trading, the money is basically loaned from a broker. Nevertheless, you can usually gain much higher leverage in forex when compared to the other markets. Why is it so? Well, here you can build up as well as control a huge amount of money for a small initial margin.
Working of Leverage in Forex Trading: Actually, the concept of leverage has been used by smart investors as well as companies for a long time now. The individual investors usually use the leverage to increase the profit on their investments. On the other hand, the companies often use the leverage technique to get the finance for their assets and hedge their foreign currency exposure. What does that mean? It means that the companies use the method of debt financing to fund their business operations in order to increase their shareholder value instead of raising their stocks. In forex trading, investors make use of the leverage to gain more from the fluctuations in between the exchange rates of the currencies of two different countries.
As a matter of fact, investors can basically achieve the highest leverage in forex. As I said earlier, leverage is actually a loan that is provided to the investors by the forex brokers. If a trader wishes to trade in the forex market, a margin account must have to be opened first with the broker.
The leverage ratio provided by brokers usually ranges from 50:1 to 500:1 depending on the broker policy and regulation. What purpose does the leverage ratio serve? The leverage ratio actually signifies the minimum margin in forex. If the leverage ratio is 50:1, then it signifies that the lowest margin requirement is 2%. Similarly, the margin requirement for the 100:1 leverage ratio can be calculated as 1% and so on. But what does it mean?
Understanding Leverage through an Example
Let us take an example to understand the leverage ratio and margin requirement in a clearer way. You already know that leverage ratio signifies the minimum margin requirement. So, if the leverage ratio is 100:1, then the minimum margin requirement is 1/100 that is 1%. It means that the trader must have at least 1% of the total trade value in the trading account as cash.
Say you would like to go long 100.000 units of EURUSD at the current price which is 1.19. Without leverage, you would need $119.000 cash in order to be able to transact this trade. On the other hand, with 100:1 leverage, you would only need $1190 cash (or margin) to invest 100.000 units of EURUSD. In practice, the forex broker loans you the difference between $119.00 and $1190 and your trade is closed if your position is in loss of $1190.
Though a leverage ratio of 100:1 may seem very risky, the leverage is the whole purpose and benefit of trading currencies with an online forex broker. That is why; it is always wise to trade with forex brokers with high leverage.
Although the chances of doubling your profits are great, there are some substantial risks too in leverage in forex trading since the value of the currencies can go in the opposite direction at any moment. This is the reason you must never trade leveraged forex without an emergency stop or a guaranteed Stop Loss order. So, be smart and trade in the forex market with leverage to earn higher profit but never without risk management.