Introduction to Forex Leverage
Leverage is the increase of profit without the increase of investments (some financial instruments like options, for instance, can be used for this purpose). In general this is borrowing some amount of money for investing in something. In forex terms, money can be borrowed from a forex broker, for example. It is possible to get high leverage in forex trading, meaning that the initial capital can be small, but a forex trader can build it up to quite a huge amount.
The margin-based leverage can be measured by means of dividing the total transaction value by the amount of margin necessary to put up.
For instance, a forex trader wants to trade standard lot of USD/JPY equivalent to $200 and is required to deposit 1% of total transaction value. In this case the required margin will be equivalent to $ 2. As a result, the margin-based leverage will constitute 100:1 (200/2).
Though, a forex trader’s risks are not necessarily influenced by the margin-based leverage. The fact is that a trader’s putting up 1% or 2% of the total transition value might not have an impact on his losses or profits. The reason of this is that a forex trader can put up a greater amount of money for position that a margin required. In this respect not the margin-based leverage but a real one should be the focus.
The real leverage is measured the following way: the total value of the forex trader’s open positions is divided by his/her trading capital. So, if a trader has $ 30, 000 in his/her account and opens $ 300 position, then the leverage he/she is trading on his/her account is 10 times (30, 000/300).
It turns out that the margin-based leverage is equivalent to the maximum real leverage a forex that can be used by a forex trader. The explanation why the margin-based leverage is different from the real leverage is that the majority of forex traders don’t apply the whole sum of money on their accounts as a margin in a single trade.
In general, speaking about forex leverage, it should be mentioned that the real leverage is a more significant and relevant indicator of profits than the margin-based one.
Written by Alexander Collins, developer of Forex expert advisor EA Shark that works on market since 2007. Follow Forexeasystems on Facebook and Twitter.