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.

[When using leverage, it's important to use risk management techniques to limit losses. Many forms of risk management fall under the technical analysis umbrella. For example, stop-loss points may be set near support or resistance levels. Investopedia's Technical Analysis Course provides an in-depth overview of these concepts and others to help you become a successful trader.]

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. How can a firm bring down its operating leverage?

    Discover how to determine a company's operating leverage and how this metric can be helpful to analysts and investors when ... Read Answer >>
Related Articles
  1. Trading

    The Basics of Forex Leveraging

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

    Forex Leverage: A Double-Edged Sword

    Find out how this flexible and customizable tool magnifies both gains and losses.
  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. 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.
  7. Investing

    The Hidden Danger of Leveraged ETFs

    Leveraged ETFs pose several dangers for retail investors tempted by potential high returns in a short period of time.
  8. Trading

    How Leverage Is Used In Forex Trading

    Forex trading by retail investors has grown by leaps and bounds in recent years, thanks to the proliferation of online trading platforms and the availability of cheap credit. The use of leverage ...
  9. Investing

    Understanding Leveraged ETFs

    A leveraged ETF uses financial derivatives and debt to amplify returns in relation to an underlying index.
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. Net Leverage

    The sum of an insurance company’s net premiums written ratio ...
  6. Leveraged Loan

    Loans extended to companies or individuals that already have ...
Hot Definitions
  1. Net Present Value - NPV

    Net Present Value (NPV) is the difference between the present values of cash inflows and outflows. Used in capital budgeting ...
  2. Return On Equity - ROE

    The amount of net income returned as a percentage of shareholders equity. Return on equity measures a corporation's profitability ...
  3. Bond

    A bond is a fixed income investment in which an investor loans money to an entity (corporate or governmental) that borrows ...
  4. Whole Life Insurance Policy

    A life insurance contract with level premiums that has both an insurance and an investment component. The insurance component ...
  5. Compound Annual Growth Rate - CAGR

    The Compound Annual Growth Rate (CAGR) is the mean annual growth rate of an investment over a specified period of time longer ...
  6. Capital Asset Pricing Model - CAPM

    A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities. ...
Trading Center