What is leverage? When most people think about investing, they think that they need large amounts of initial capital in order to start. While this may be the case for stocks, bonds and other investments, Forex is much more accessible due to the use of leverage. So how does leverage affect your trading?
To explain, think of buying a home. You may want to buy a property that is worth $100,000, so you go to a bank to take out a loan or mortgage. The bank requests that you supply 20% of the property as a down payment on your loan. So for $20,000, you are now able to enter into ownership of a $100,000 home. This is an illustration of leverage in real estate.
You have bought the home at a leverage of 5 to 1, since $20,000 is one fifth of $100,000. One year later, the property market has appreciated by 50% and you decide to sell the property for $150,000, making a $50,000 profit.
If you had not taken out a bank loan and had used only your $20,000 to buy a small studio which cost that amount, your total profit after a 50% property price increase would have been only $10,000. Your 5 to 1 leverage has allowed you to earn 5 times more than you would have if you had traded without leverage. Let's see how we can apply leverage to a forex deal.
You currently have 1,000 euros to invest and you decide to buy 100,000 euros worth of Euro-US dollars at a rate of 1.3130. Since 1,000 is one hundredth of 100,000, you're using a leverage of 100 to 1. The Euro-US dollar rate then moves up to 1.3140 and you decide to close your deal, making a 10 pip profit.
Using the PIP formula from the What is a PIP video, you can calculate that your total profit is $100. If you had not traded with leverage, you would have only made a $1 profit. In fact, depending on your account type and risk preference, you can trade much smaller or larger deal sizes and use different levels of leverage.
It is important that you keep in mind that higher leverage can increase your potential profits, but it can also lead to bigger potential losses. Due to this risk, we encourage traders to plan their trades well by making sure they employ a risk management strategy and keep learning about the market.
