What is leverage and how does it work?
Many speculators find forex trading an attractive option because of the large amount of leverage it offers. Leverage refers to the use of a small quantity of one asset to have an effect over a larger amount of another asset. In forex trading, it takes only a relatively small amount of capital to initiate a significantly larger sized trade. Because of this, a high rate of possible leverage means that the size of your trades are not limited by the capital in your bank account.
Leverage is typically expressed as a ratio. For example, a 50:1 leverage ratio
means that for every $1 you have in your account, you can place a trade worth $50. In this particular case, a trader would only need to deposit 2% of the intended trade to proceed with a particular position/ (1/50 = 0.02 = 2%). So theoretically, to trade $100,000 of currency, only a $2,000 deposit would be required.
Alternatively, trading in solid assets would limit a trader by the sum of capital in that currency that he owned. For example, if a trader had £1, they could only trade £1 worth of currency.
When trading forex, each currency pair can have a different leverage scale. For example, the leverage on pairs offered by ETX Capital varies, from 14:1 EUR/HUF (Euro/Hungarian Forint) to 200:1 for pairs such as EUR/USD and GBP/USD (traders should keep in mind that leverage settings are changeable based on market conditions).
However, it is important to be aware of both the benefits and pitfalls of using leverage. When making a profit on leveraged investments, the returns can be large. Nonetheless, the risk of losses can be equally significant if the market moves in the opposite direction to one’s trade. Because of this, increasing the leverage scale increases the risk of a trade, and it takes education and experience to know when to use leverage and to what extent.