Friend or Foe; Leverage – The Doubled Edged Sword
One of the many reasons why Forex Trading is popular compared to other financial instruments is that with Forex, you can get usually similar or higher leverage than you would with stocks. Many have heard of the word “leverage”, but few know it’s definition, how leverage works, and most importantly how it directly impacts them.
What is Leverage?
The definition of leverage is the ability to control a larger amount of money while using none or little of your own money and borrowing the rest. In the case of Forex Trading, brokers offer high leverage for a margin requirement (think deposit money to open a trade with the broker),
How Leverage Works?
For example, if you are required to deposit 1% of the total transaction value as margin and you intend to trade one standard lot, which is equivalent to USD100,000, the margin required would be USD1,000 (You will need at least USD1000 in your account). Thus, your margin-based leverage will be 100:1 (100,000/1,000).
|Margin-Based Leverage Expressed as Ratio||Margin Required of Total Transaction Value|
table showing how Leverage interacts with Margin
How will it impact you?
For example, to enter a USD100,000 (1 Lot) trade, the broker will set aside USD1,000 from your account. Your leverage, which is expressed in ratios, is now 100:1.
You’re now controlling USD100,000 with USD1,000Let’s say you’ve made USD100 on the trade.
The broker only had to set aside $1,000 of your money, so your return is a groovy 10% (USD100 profit / USD1000 capital).
Imagine having to come out with the entire USD100,000 to earn USD100.. not very impressive isn’t it.
But it is also double-edged.
Leverage will amplify not only your profits but also your losses.
Gaining 10% compared to 0.1% feels good, but not so much when we’re losing 10% instead of 0.1%.
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