A:

The concept of leverage is used by both investors and companies. Investors use leverage to significantly increase the returns that can be provided on an investment. They lever their investments by using various instruments that include options, futures, and margin accounts. Companies can use leverage to finance their assets. In other words, instead of issuing stock to raise capital, companies can use debt financing to invest in business operations in an attempt to increase shareholder value. (For more insight, see What do people mean when they say that debt is a relatively cheaper form of finance than equity?)

In forex, investors use leverage to profit from the fluctuations in exchange rates between two different countries. The leverage that is achievable in the forex market is one of the highest that investors can obtain. Leverage is a loan that is provided to an investor by the broker that is handling the investor's or trader's forex account. When a trader decides to trade in the forex market, he or she must first open a margin account with a forex broker. Usually, the amount of leverage provided is either 50:1, 100:1 or 200:1, depending on the broker and the size of the position that the investor is trading. what does this mean? A 50:1 leverage ratio means that the minimum margin requirement for the trader is 1/50 = 2%. A 100:1 ratio means that the trader is required to have at least 1/100 = 1% of the total value of trade available as cash in the trading account, and so on. Standard trading is done on 100,000 units of currency, so for a trade of this size, the leverage provided is usually 50:1 or 100:1. Leverage of 200:1 is usually used for positions of $50,000 or less.

To trade $100,000 of currency, with a margin of 1%, an investor will only have to deposit $1,000 into his or her margin account. The leverage provided on a trade like this is 100:1. Leverage of this size is significantly larger than the 2:1 leverage commonly provided on equities and the 15:1 leverage provided in the futures market. Although 100:1 leverage may seem extremely risky, the risk is significantly less when you consider that currency prices usually change by less than 1% during intraday trading. If currencies fluctuated as much as equities, brokers would not be able to provide as much leverage.

Although the ability to earn significant profits by using leverage is substantial, leverage can also work against investors. For example, if the currency underlying one of your trades moves in the opposite direction of what you believed would happen, leverage will greatly amplify the potential losses. To avoid such a catastrophe, forex traders usually implement a strict trading style that includes the use of stop and limit orders.

Let's go deeper into the use of leverage and trading strategies - Read Margin Trading, Which Order to Use? Stop-Loss or Stop-Limit?, and Forex Leverage: A Double-Edged Sword.

RELATED FAQS
  1. What are the risks of having both high operating leverage and high financial leverage?

    In finance, the term leverage arises often. Both investors and companies employ leverage to generate greater returns on their ... Read Answer >>
  2. Besides operating leverage, what are other important forms of leverage for businesses?

    Learn about what other forms of leverage exist for businesses besides operational leverage, and the primary leverage metrics ... Read Answer >>
  3. Can mutual funds use leverage?

    Learn about what types of mutual funds use leverage, how leverage can increase returns and what restrictions are in place ... Read Answer >>
  4. What methods can be used to fund a forex account?

    The forex market is where currencies from around the world are traded. In the past, currency trading was limited to certain ... Read Answer >>
  5. What is the difference between operating leverage and financial leverage?

    Discover the two equity valuation metrics, operating leverage and financial leverage, how they are similar and what differentiates ... Read Answer >>
  6. What is "leverage" as it is used in closed-end funds?

    A distinguishing feature of closed-end funds is their ability to use borrowing as a method to leverage their assets. An ideal ... Read Answer >>
Related Articles
  1. Trading

    The Basics of Forex Leveraging

    A closer look at the controversial topic of leverage in forex trading.
  2. Trading

    Adding Leverage To Your Forex Trading

    The use of margin to trade in the foreign exchange market can magnify profit opportunities.
  3. Investing

    Leverage: Is It Good for Your Portfolio?

    Discover the concept of financial leverage. Learn multiple ways to get leverage in your portfolio, and decide if leverage is a good idea for you.
  4. Investing

    Leverage's "Double-Edged Sword" Need Not Cut Deep

    Learn to cut out losses quickly, leaving profits room to grow.
  5. Personal Finance

    Borrowing Smart In A Debt-Filled World

    Leveraging your money can have many perks, but it's not always the smartest financial plan.
  6. Investing

    Explaining Leveraged Loans

    Leveraged loans are loans extended to companies or people who already have large amounts of debt.
  7. Investing

    5 Ways Debt Can Make You Money

    While debt can be a negative, it can also be a positive thing if used properly. Find out how debt can actually make you richer.
  8. Managing Wealth

    Leveraging Leverage For Bigger Profits

    Leverage is like fire. Find out how to use it to heat up your investing without burning your portfolio.
  9. Financial Advisor

    Why Leveraged ETFs Are Not a Long-Term Bet

    Leveraged ETFs aren't for the average investor. They can, however, present significant upside potential for the right type of trader.
RELATED TERMS
  1. Maximum Leverage

    The maximum size of a trading position permitted through a leveraged ...
  2. Leverage

    The use of various financial instruments or borrowed capital, ...
  3. Leveraged ETF

    An exchange-traded fund (ETF) that uses financial derivatives ...
  4. Leverage Build Up

    The accumulation of additional debt to enter a position that ...
  5. Trading Margin Excess

    The funds that remain in a margin trading account that are available ...
  6. Degree Of Combined Leverage - DCL

    A leverage ratio that summarizes the combined effect the degree ...
Hot Definitions
  1. Ponzi Scheme

    A fraudulent investing scam promising high rates of return with little risk to investors. The Ponzi scheme generates returns ...
  2. Dow Jones Industrial Average - DJIA

    The Dow Jones Industrial Average is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange ...
  3. Revolving Credit

    A line of credit where the customer pays a commitment fee and is then allowed to use the funds when they are needed. It is ...
  4. Marginal Utility

    The additional satisfaction a consumer gains from consuming one more unit of a good or service. Marginal utility is an important ...
  5. Contango

    A situation where the futures price of a commodity is above the expected future spot price. Contango refers to a situation ...
  6. Stop-Loss Order

    An order placed with a broker to sell a security when it reaches a certain price. A stop-loss order is designed to limit ...
Trading Center