Forex Leverage Explained

Through forex leverage, the foreign exchange trader is able to take control of a large investment fund in currencies with only a relatively small amount of deposit. With leverage, trading profits, as well as losses, are magnified relative to the amount of funds invested. Small or individual investors cannot do well in their forex trading activities without the help of a moderate to high level of leverage.

Forex Trading in a Nutshell

Foreign Exchange trading involves currency pairs where investors make directional placements on the changes in the relative values of each currency in the traded pair.

To illustrate, take the euro against the US dollar. If the quoted exchange rate for the pair is EUR/USD $1.3805, it means that the value of the first named currency (EUR) in the second currency (USD) is $1.3805. Note that forex trading is quoted up to 4 decimal places.

A trader will place a buy order if he thinks the euro will appreciate vs. the dollar. On the other hand, a sell order will be made if he expects the euro price to fall in relation to the dollar.

How Forex Leverage Affects Trading

Usually, brokers allow trading leverage at 50:1, 100:1, or even up to 400:1. The ratio dictates the amount of margin the traders must have in their trading accounts in order to buy or sell. Based on the previous example, for a transaction of 100,000 of the EUR/USD pair, the trade would be valued at $138,050 computed on the quoted price above.

At a leverage of 100:1, the trader needs to have a $1,380.50 margin deposit which is 1/100 of the value of the trade. For a leverage ratio of 50:1, the required deposit would be twice as much.

Why Leverage Is Necessary

The incremental changes in currency exchange rate values are measured in $0.0001 or 1/100 of a cent. This is called a pip in forex terminology. Currency prices can fluctuate anywhere from a few pips to several hundreds of pips on a daily basis. For $10k worth of currency, this can translate into a few dollars to several hundred dollars.

No trader would be willing to shell out as much as $10,000 just to profit or lose $50 or less in a trading day. Thus, for a 100:1 leverage, the trader would only be required a deposit of $100. The relatively small amount of deposit and the possible gains are what make leveraging very lucrative for short term traders.

Leverage Regulations

A forex broker can be established in any of the designated countries around the world and accept deposits from investors who can then begin trading. The regulations that govern the operations of a particular broker depend on local laws. Likewise, the extent of leverage that a broker can allow is set by the broker’s home country. In many cases, a 100:1 leverage is available. In the United States, however, the leverage level that US-based brokers can offer is only up to 50:1 as set by the US Commodity Futures Trading Commission in 2010.

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