What is a “leverage effect”?

It is possible to aim for high returns using leverage on the Forex market

The word “leverage” can find its origins in the word “lever,” a tool made for lifting or moving a large object with little power put forth from the operator. In economic terms, “leverage” means increasing profit margins on capital by using other trader’s capital. In the Forex market, leverage is placed on a relatively small deposit to allow the trading of larger amounts of money for larger profits. The ability to use leverage in this way is one of the selling points of Forex trading.


Pros to using leverage

As mentioned above, the biggest pro to using leverage is the extremely high returns that can be achieved through its use. Without leverage, it is possible that the rather high handing fees and wide spreads (price margin) would make Forex trading difficult without individual traders having to invest a lot of initial capital into the market. However, with the offer of low (or no) handing fees, narrow spreads, and high leverage backing these features up, individual traders can trade with ease. Without leverage, the allure of Forex trading would be significantly decreased.


Cons to using leverage

The use of leverage in the Forex market is considered to be a high risk, high return method of trading and making money. If the trade does not go well, then a trader stands to lose everything they put into the trade and more. This double-edged sword aspect of leverage makes managing your funds well all the more important. Furthermore, there are companies that offer a system where the trader isn’t billed for any losses exceeding their account balance. This system is called Negative Balance Protection, and it helps dull one edge of the double-edged sword.


An example of the effect of leverage on a Forex trade

1:500 Leverage

If you deposit 1,000USD into an account with 1:500 leverage, it is possible to trade up to 500,000USD. USD/EUR can be traded at a max of 400,000 units of currency. If you trade at that 400,000 units of currency maximum, here is an example of what the math could look like.

 Deposit: 1,000USD
 Leverage: 1:500
 Transaction amount: 400,000 units of currency

If you buy at 1USD=1.250000EUR, and then sell when 1USD=1.260000EUR, you can make a 4,000USD profit.

400,000×100pips×0.0001=4000USD(exchange gain)

In this case, it was possible to make a 4,000USD profit off of 1,000USD due to 100pips worth of difference between the buying and selling prices. This is a case of high risk with high return.


However, there is always the possibility that the dream of 100pips will not be achieved, and the trade will be conducted at 25pips in the opposite direction instead. In that case, the 1000USD that you put in would be lost.

400,000×25pips×0.0001=1,000USD(exchange loss)

Of course, the above examples use leverage to the fullest 50,000%. If the leverage rate is 1:500, then it is possible to trade with rates anywhere from 1:1 to 1:500, so it is possible for you to choose a leverage rate that matches the level of risk you are willing or able to take.


Leverage rates vary by company

The biggest selling point of Forex trading, leverage, has rates that vary by company. In general, leverage ranges from about 1:400 to 1:500; however some companies offer maximum rates as low as 1:200 or as high as over 1:1000. Depending on the country and its laws, some Forex companies cannot even offer a maximum of 1:200. It may feel natural to want to choose the company offering the highest leverage, but one of the most important parts of Forex trading is fund management, so it is best to choose a company offering leverage rates that are right for you and your trading style.