If you ask folks what differentiates forex trading from stock trading, they will often name leverage as one of the factors. But what is leverage, and why does it matter so much in currency trading?
Leverage is like a financial superpower. It allows you to take on a considerably larger trading position with only a small amount of your own funds at risk. You can think of leverage as borrowed power from your broker or as a way to increase your trading position size considerably with a relatively small amount of your own money.
For example, when trading in forex, instead of requiring $100,000 to trade one standard forex lot, you would only need a mortgage of $1000 of your own capital with 100:1 leverage.
Leverage is important in forex trading because currency price movements are typically measured in very small increments, called pips. Without leverage, most retail traders would only make small amounts of profit from small price movements. EUR/USD might only move 50 pips to reap only a couple of dollars of profit without leverage, but with leverage properly employed, that same move might easily yield hundreds of dollars instead.
Definition & How Leverage Actually Works
Leverage means multiplying your own capital (called margin) to control a trade size that is greater than the amount in your trading account. Think of it as a loan from your broker and essentially a way to leverage your trading in greater size than your account balance.
Here is where it gets serious. If your trade moves against you towards your margin, and your losses are near your deposit margin, your broker will issue you a margin call, which is a warning that either more funds have to be deposited or you will have to close some of your positions. If this does not happen, the broker will automatically close your positions out, so you cannot lose more than your own account balance. This will be referred to as a stop-out.
Everyday analogy: leverage made easy for beginners
When we were kids on the playground, we'd sometimes play seesaws. Remember when you wanted to lift your heavier friend? You couldn't do it with just your weight. As soon as you scooted back on your side of the seesaw, (using a longer lever), you could easily lift your friend.
Forex leverage can be understood the same way. Your small deposit (you) is located at the end of a long financial lever. You can "lift" or control a much larger position in the market (your bigger friend). Obviously, the longer the lever (higher leverage ratio) you have, the more you will be able to control the same amount of effort (capital).
Benefits of Using Leverage: Maximize Capital Efficiency
The most blatant advantage of leverage is that it greatly lowers the economic threshold required to get into the forex market. Without leverage, you'd need significant capital to capitalize on even modest profits from the slight price perturbations that characterize the currency markets. In forex terms, a standard lot will require 100,000 units of the base currency – this is a pretty substantial capital investment for most retail traders.
With leverage, a trader with $5,000 can control the same position size as a trader with $500,000 without leverage. Leverage enhances equality of access to forex markets and enables still meaningful transaction engagement for traders, even as they start out with small capital.
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