May 30, 2012

What is Leverage in Forex?

For investors and traders, not only in forex but in other markets as well (stocks, futures, options, real estate, film making, TV show production, etc.), leverage is both an effective tool and a potentially dangerous one.

Leverage is the use of borrowed funds to invest, trade, or otherwise do business.
Whether you're a studio borrowing 300 million US dollars to make a film that ends up grossing more than 1 billion, or you're a trader who borrowed 100,000 to make $500 -- it's leverage.

Of course, money isn't free. Traditionally, businesses of all kinds -- from local store owners to Walmart -- need to borrow in order to run the business. If successful, the assumption is that the borrowed funds will be paid back and the profits will be kept by the investor/business (less the interest owed to the lender.)

In the forex market, the same logic applies: the trader puts up "margin" (collateral for the loan) and absorbs the profits or losses that result from each trade.

For example, if a broker offers 100:1 leverage, then for every $100 you deposit, you can trade up to $10,000 worth of currency. (In reality, you should NEVER trade with maximum leverage no matter how tempting it may be. This is an example to illustrate the concept.)

(Sometimes it's written as 1:100, but the numbers themselves should make it obvious which is which. It should be clear that you wouldn't need to put up $10,000 cash just to borrow $100 for a trade.)

Since these FAQs are here to cover the very basics for beginners, I'll add that you never actually need to worry about the process each time you make use of leverage.

When you deposit funds into a margin account -- whether it's for forex, stocks, futures, or other -- you're automatically offered a certain amount of leverage. It's your choice how much of it to use -- and I encourage you to learn effective money management skills before making use of this leverage.

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