When it comes to Forex trading, brokers often extend the option of leverage to their traders in order to trade a larger amount of funds than would be available on their own.
The concept of leverage is used by both investors and companies. Leverage helps both the investor and the firm to invest or operate. And in the world of business, a company can use leverage to try to generate shareholder wealth, but if it fails to do so, the interest expense and credit risk of default destroys shareholder value.
Forex traders use leverage to significantly increase the returns that can be provided on their investment. Forex brokers offer leverage to their clients so they can profit from the fluctuations in exchange rates between two different countries.
The leverage that is achievable in the Forex market is often very high. Leverage is a loan that is extended to a trader by the broker that is handling his or her Forex account. Before he investor can place a trade, he must first open up a margin account with a broker. The amount of leverage starts at 50:1, and can sometimes reach 500:1 depending on the broker and the size of the position the investor is trading. Since standard trading is done on 100,000 units of currency, the leverage on a trade of this size is usually 50:1 or 100:1. Leverage of 200:1 is usually used for positions of $50,000 or less.
For example, a trader wishing to trade $100,000 can use a margin of 1%, and have to deposit only $1,000 into his margin account. The leverage provided on a trade like this is 100:1. This leverage may seem extremely risky. However, the risk is significantly less when you reflect that currency prices usually change by less than 1% during intraday trading.
Despite the capability for traders to earn substantial profits by using leverage, traders must keep in mind that this same leverage can also work against him. Should the currency underlying a trade move in the opposite direction of what a trader thought would occur, leverage will greatly amplify the potential losses and he will be out of pocket a considerable amount of money. To avoid such a misfortune, Forex traders can implement a strict trading style that includes the use of stop and limit orders and other precautionary moves.