Forex leverage refers to investing in the forex market on a credit basis or by using debt.
Before moving on to forex leverage, let's understand the term'leverage.' Leverage means making investments with borrowed money.
Example 1: Let's say you have $1,000 with you, and you want to purchase stocks or shares worth $2,000. To cover the deficit, you borrow $1,000 from your friend. Such a transaction is called trading using leverage.
Similar to the example above, forex leverage means trading on the forex market using leverage. You trade more than the funds available with you so that you can make a bigger profit.
Example 2: Continuing with the above example let's say you have $1,000 in your forex account. You've read some positive news about the Japanese economy, and you believe the demand for yen is going to increase. You borrow $1,000 from your broker and buy yen worth $2,000 (including your own $1,000.) This is called as forex leverage.
Among all the other financial instruments, the forex market provides one of the highest leverage. That's because the movements in forex rates are usually very small. For example, as of November 6, 2014, the USD-GBP rate is at 0.6284. In the past 1 month, the lowest rate touched by this pair is 0.6180 and the highest is 0.6296.
As you can see, the price movement is fractional. If someone purchases one or two or even 1,000 units of this currency pair for trading, there is very limited scope for any profit. To counter this, brokerages offer high leverage of up to 100, 200 or even 400 times of the original amount for forex trading. Also, unlike stocks, forex brokers don't charge any interest on the leverage amount.
Example 3: Suppose your broker provides you with leverage of 100:1. With $100, you can buy forex worth $10,000. Let's say you bought GBP-USD pair for $10,000 on 5th November at a rate of 1.5882 (approximately 6,296 units). And on 6th November, the unit price increased to 1.5988, and you sold all the 6,296 units for $10,066. Thanks to the leverage you have made a gain of $66 on the original investment.
Note the above example is only for illustrative purposes, and things are not as rosy in the real world. At times, you will end up losing very high amounts because of leverage, so you need to be very careful. If you are trading in forex, you should invest very small amounts. This way, even if you lose the amount, it won't make a major difference to your finances.
Ideally you should not use more than 10% of leverage available to you. So even if your broker has provided a leverage of 100:1, you should not use more than 10:1.
Use our Forex margin calculator to determine your'margin used' in relation to the margin ratio and the number of units.
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