Leverage is borrowed funds provided by a brokerage company to carry out transactions. It enables a trader to make trades, which volume exceeds own funds placed on brokerage account by tens or hundreds times. It gives rise to immense prospects for profit-taking, but also increases risks.
Leverage can be changed in a wide range starting from 1:1 and ending with 1:1000. It is a common wisdom that leverage of 1:100 is a gold standard. For example, if a broker offers a trader a leverage of 1:50, it means that the broker provides access to funds 50 times larger than the client’s ones. In other words, the trader has got a possibility to make trades of the volume exceeding his/her funds by 50 times.
Required margin / deposit
Does leverage affect trading results in any way? Let’s take more examples to better understand it.
Forex leverage and margin explained
Example 1. Leverage is not used. A trader funds personal account with $1,000 to buy a block of shares. He/she finds the required issuer (asset), which share is worth $100 each. So, having $1,000 deposit, the trader will be able to buy as much as 10 similar shares. It is impossible to buy more shares, since all the funds have been used.
Example 2. Leverage is used. Brokerage account is deposited with $1,000. A broker offers a leverage of 1:100. The trader can make trades, which volume exceeds his/her deposit by 100 times. If the trader could buy 10 shares in the first case, now he/she can buy 1000 shares by using leverage. The potential income from the trade will increase by 100 times.
It should be understood that a higher leverage not only has an effect on your potential income, but inevitably results in an increased risk.
Example 1. Leverage is not used. The trader buys 10 shares worth $100 each in anticipation of a further rise of the price. His/her forecast happens to be wrong, and the price per share declines to $99. The trader will lose $1 per one bought share or $10 per 10 shares in total. The trader’s deposit will eventually reduce to $990.
Example 2. Leverage is used. The trader uses a leverage of 1:10 and buys 100 shares worth $100 each. He/she anticipates a further rise of the price per share, but the forecast happens to be wrong. The price per share declines to $99. The trader loses $1 per one share. Given that he/she bought 100 shares, losses will amount to $100.
Therefore, a trader can earn an income or incur losses, which are ten times greater depending on the leverage used, in case the price changes equally in both cases.
High leverage proportionally increases not only a potential income, but also potential losses. Forex trader should use the leverage responsibly to minimize risks.