Leverage

Razvan Mihai

Analyst

Leverage is also a noteworthy feature of CFDs and Forex Trading. Forex has become so popular thanks to leverage. In simpler words, leverage is the ability to trade larger amounts of money with a guarantee.

As a result of the opportunity to trade more money than is currently deposited in the account, the risks have increased. The balance multiplied by the leverage has introduced the prospect of making huge profits.

Let us assume you would like to speculate the evolution of the EURUSD price. However, your current balance is 1000 Euros, which is available for use. With this amount of money you could visit your nearest bank or exchange house to sell your Euros and receive US Dollars. You may sell 1000 Euros at a currency rate (bid) of 1.1100 because you gained insight that in the following days the dollar will appreciate against the European single currency. You now have $1110. After a few days you return to the exchange house to collect your 1000 Euros at 1.1000 (ask price), and only pay $1100. This gives you a profit of 10 dollars for this trade or approximately 10 Euros.

Now imagine having the opportunity to carry out the same trades with 10.000 Euros. Ten times the money to trade means that your profit would increase ten times. What if you had 100.000 Euros? The profit would be 100 times bigger for the same trade.

Taking the same transaction to a brokerage house would give you the prospect to use leverages from 1:1 (meaning that you trade only what you have), 1:50 (50 times the amount you have), 1:100 (most commonly, the opportunity to trade 100 times your amount) or even extend all the way to 1:1000 (1000 times the amount you have).

As I said, using leverage is risky. Big losses can occur if a trader does not use safety precautions. And so when this transpires a trader will lose all the money they invested. A trader wins from the trade, the profit will be added to his initial deposit.

For example, you have 1000 Euros that you invest into Forex trading. You open a trading account at a brokerage company offering a leverage of 1:100, and deposit into the account. The price of EURUSD is 1.1100 and you decide to sell your Euros because you assume he US Dollar will gain in the following days. On this occasion you use the leverage given by the brokerage house of 1:100. So with 1000 guarantee you trade 100.000.

The price drops to 1.1000 and you decide to get your euros back so you buy at this price. This time with the leverage applied you win 100 times more, 1000 dollars. Let’s assume the price drops only to 1.1050. In this case, you would have earned 500 dollars, which were added to your initial balance. Even supposing the price movement was two times smaller than in the other example, the profit is 50 times larger.

As you can see, leverage gives traders the opportunity to make more money on smaller price movements and smaller investments.


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