Leverage means investing using money you’ve borrowed, usually from a broker.
When you trade on leverage, you pay your broker a sum of money called initial margin. This is worked out as a proportion of the total value of the trade and acts as a security deposit. The broker then extends a line of credit which you can use to make bigger trades.
Once your trades close, you repay the money you’ve borrowed, less the margin you’ve already paid. If the trades have gone your way, you pocket the difference. This is your profit.
Most of us have used leverage at some point in our lives without even realising it. Case in point, a mortgage is a type of leverage. You put down a deposit and borrow the rest. This allows you to buy a bigger house than you’d be able to afford (if you could afford one at all).
Leverage is common in trading for the same reason. When you use leverage, you can invest more than you would otherwise be able to afford. Which means you can greatly increase your returns.
The flipside, of course, is that if your trades go badly, you could end up with huge debts.
Imagine you wanted to bet that the British Pound’s value against the Euro will decrease. You have £1,000 to invest.
To make this ‘bet’, you’d exchange your £1,000 for Euro.
Let’s say the GBP/EUR exchange rate is 1.10. This means your £1,000 are worth €1,100.
Now, you wait.
The market moves in your favour and the GBP/EUR exchange rate goes down from 1.10 to 1.05. So you exchange your €1,100 back into British Pounds and get £1,048 — £48 profit.
Leverage can increase this profit significantly.
Imagine your broker sets the initial margin at 10%. This means that, if you invest €1,000, the broker will lend you €9,000, bringing your total investment up to €10,000.
Using our same example, on a movement from 1.10 to 1.05, your profit would now be £476.
Needless to say, the opposite is also true.
If the exchange rate went up to 1.2 instead of going down to 1.05, you’d lose £83 on your unleveraged trade and a whopping £833 on your leveraged trade.
- Leverage is typically expressed as a ratio. The ratio shows the actual size of the trade relative to the initial margin the broker holds. So, the leverage on a €10,000 trade on which you’ve posted €1,000 initial margin, for instance, would be 10:1.
- One of the main reasons the forex market is popular with speculators — people who trade purely for profit — is that the amount of leverage available is much higher than it is on other markets such as the stock market.
- At one point, leverage was spiralling out of control, with brokers offering leverage of 2000:1 or more, meaning you could invest 2 million or more with a 1,000 investment.
- Because high amounts of leverage can lead to catastrophic losses, regulators have stepped in. In 2018, for instance, the European Securities and Markets Authority limited the leverage on major currency pairs like EUR/USD to 30:1 and the leverage on minor currency pairs to 20:1.
Want to know more?
- Back in 2015, when regulatory intervention to limit leverage was still under discussion, trader Muhammad Atif made a case for keeping the status quo. In this article, he argues that, because forex markets tend to move slowly (when they’re not blowing up), capping leverage will ultimately hurt investors by lowering their returns.
- This article takes the diametrically opposite view, arguing that low leverage is the way to go if you want to succeed as a forex trader.
“Leverage is a double-edged sword. It can greatly increase your profit or lead you into debt, so don’t get carried away. As with any investment, things can go either way if you’re speculating. So never invest more than you can afford to lose.”