How does leverage work in the forex market?

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 his or her forex account. When an investor decides to invest in the forex market, he or she must first open up a margin account with a 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 the investor is trading. 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 by 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.

To learn more, see Getting Started In Forex, A Primer On The Forex Market and Getting Started In Foreign Exchange Futures.

RELATED FAQS

  1. Why does the Federal Reserve Board regulate which stocks can be bought on margin?

    Find out why the Federal Reserve Board began regulating margin stock purchases in 1934 and why margin requirements do not ...
  2. What is the difference between a long position and a call option?

    Learn what a long position in a stock is, what a call option is, and the difference between owning shares of a company and ...
  3. Why does delta only range from 1 to -1?

    Learn what the option Greek delta is, what affects the value of delta for an option and why the delta of an option can only ...
  4. What is the difference between pips, points, and ticks?

    Learn the differences between points, ticks and pips and how each are used by investors to measure price changes in stocks, ...
RELATED TERMS
  1. Catastrophe Equity Put (CatEPut)

    Catastrophe equity puts are used to ensure that insurance companies ...
  2. Open Trade Equity (OTE)

    Open trade equity (OTE) is the equity in an open futures contract.
  3. Leverage Ratio

    Any ratio used to calculate the financial leverage of a company ...
  4. Ceded Reinsurance Leverage

    The ratio of ceded insurance balances to policyholders’ surplus. ...
  5. Multibank Holding Company

    A company that owns or controls two or more banks. Mutlibank ...
  6. Short Put

    A type of strategy regarding a put option, which is a contract ...

You May Also Like

Related Articles
  1. Options & Futures

    Examples Of Exchange-Traded Derivatives

  2. Options & Futures

    Advantages Of Trading Futures Over Stocks

  3. Stock Analysis

    Is Prospect Capital Exposed To Elevated ...

  4. Trading Strategies

    Top Day Trading Instruments

  5. Mutual Funds & ETFs

    Buying ETFs on Margin Versus Leveraged ...

Trading Center