The Role of Leverage in Forex Trading
In this lesson, we’ll look at leverage and its role in forex trading.
What is leverage?
Leverage is an investment strategy that uses borrowed capital to increase the potential return
of an investment. Basically, leverage allows you to control a large position using only a small
portion of your funds and borrowing the rest.
How leverage works
In retail FX trading, traders use CFDs (Contracts for Difference) to trade currency pairs with
leverage. For example, with leverage of 1:100 the broker will set aside only $1000 to allow
you to control a position worth $100,000. This means you are “trading on a margin” with your
$1,000 being the margin.
Example of leverage:
If EUR/USD is trading at 1.1000:
1:10 leverage: For an investment of €10,000, you need to put up 1/10th of the investment as
a margin, which is €1,000.
1:100 leverage: For the same investment (€10,000), you need to commit only €100 or $110
as your margin.
1:500 leverage: The required margin for an investment of €10,000 would be €20 or $22.
Leverage is a double-edged sword
Leverage can significantly amplify your returns:
Higher return: With higher leverage, the amount you commit from your own funds is much
lower than the actual investment size, leading to much higher returns.
High Risk: A small price movement against your position means you can lose the entire
amount you committed.
Scenario:
If EUR/USD goes up from 1.1000 to 1.1100, closing your position would give a profit of $100
calculated as the difference between the exchange rate (1.11) and the opening price of the
position (1.10), representing a movement of 0.01. Multiplying this by the investment size
(10,000) gives a profit of $100 USD.
If your leverage is 1:1, essentially no leverage, the profit margin would be less than 1% as you
would earn $100 by committing $11,000.
On the other hand, with a leverage of 1:500, the profit margin rises to 455%. This means that
you would gain $100 by setting aside only $22.
Leverage acts as a magnifying glass. A small change in your position can lead to a significant
change in your profit/loss. Higher leverage means higher risk.
Therefore, it’s crucial to carefully consider the level of leverage that matches your risk
tolerance and investment strategy.