In Forex trading, leverage can be defined as a loan extended to a Forex trader by a Forex broker. Leverage is expresses as a ratio. It is based on margin requirements imposed by Forex brokers.
When a person decides to become a Forex trader, he/she must open an account with a Forex broker. Forex traders usually open special types of accounts known as Forex margin accounts. A Forex margin account isn’t different from a typical margin account. The main difference is that; a Forex trader can be able to take large short-term loans from their broker.
A Forex trader must however deposit money into their account first before this happens. Also, the loans aren’t extended typically. Forex traders can only take loans when they open trades and this is where the concept of leverage in Forex trading comes in clearly.
The leverage concept
Forex brokers requires Forex traders to have a certain percentage of the value of any trade available as cash in their account before proceeding to place any trade. Different Forex brokers have different requirements depending on factors such as the size of a trading position. Typically, a trader is supposed to have at least 2% of the value of any trader available as cash (in their trading account) before placing any trade. Leverage is usually expressed as a ratio so a 2% requirement equals to 50:1 leverage ratio i.e. 1/50 expressed as a percentage = 1/50 x 100 = 2%.
The most common leverage provided by Forex brokers is 50:1, 100:1 and 200:1. As mentioned above, a 50:1 leverage ratio means a trader must have at least 2% cash in their account or what is referred to as margin in Forex trading. A 100:1 leverage ratio means a trader must have at least 1% cash/margin in their account. A 200:1 ratio means a trader must have at least 0.5% margin etc.
Although the above ratios are the most common, it’s important to note that brokers can offer more ratios depending on factors like trading size. Standard trading is usually done using standard lots i.e. 100,000 currency units so the leverage provided is usually; 50:1 or 100:1. A 200:1 leverage is usually offered for accounts with $50,000 capital or less.
A leverage ratio of 100:1 makes it possible to trade with $100,000 when you have $1,000 only in your margin account. Although this type of leverage seems very risky, the risk isn’t as high as you would think since currencies fluctuate by less than one percent in typical trading days. Nevertheless, it’s important to note that you can easily blow up your account if you are trading with high leverage and the market goes against you. The opposite is also true.
Leverage is a powerful tool in Forex. As mentioned above, leverage is a loan. Leverage enables forex traders to trade with more money than they actually have. Forex brokers are able to give higher leverage than other financial institutions since currencies make very small percentage moves upwards or downwards on a daily basis. Although leverage can increase the potential for making lots of money with a small deposit, the potential for making huge losses is also high if a Forex trader happens to be on the wrong side of a trade.