Forex leverage – When reading about Forex, one of the main characteristics people notice is the extremely high Forex leverage. But what does that mean? Is it a good thing or a bad thing?
Let’s answer the easy question first: leverage in Forex markets refers to the use of borrowed funds to increase the return on the investment. It enables traders to enter deals they could not otherwise afford, due to sheer lack of funds. In Forex markets, traders can borrow up to 99% of the capital required by the trade in question. In other words, Forex markets enable you to make trades up to 100 times larger than you normally could – far larger than any other type of financial market in the world, generating far greater returns on the amount they did invest, after repaying the difference. However, this does not come without risk. That difference (and often the interest on it) have to be repaid, and the profit from the trade has to be large enough to cover it, along with the initial investment, and whatever remains is what you get to keep.
Why use it?
The difference between funding a deal using entirely your own money and funding it through borrowed funds is the relation between your profit and the initial investment. Hypothetically speaking, you stand to gain more by funding deals through leverage than relying solely on your funds. The reason is simple: by distributing your funds over several deals and using Forex leverage to cover the rest, you could make more money than by just putting all your eggs into one basket – yes, you also mitigate the risk, to an extent; in a sense you won’t go bust in a single deal. However, the amount you have to earn to cover the costs and come out on top also increases, and if the deal falls through (or falls short), you could find yourself in a serious predicament – even if you somehow managed to repay the leveraged funds, you would still lose many times what you have invested in your own money.
As to the reason why leverage is such a big deal in Forex markets, the reason is simple. Currency pairs are monitored in pips which either go up or down – they are the smallest recorded change in that pair’s price. Those are very small, the actual change in price measuring in 3 or 4 decimals for each pip (0.0001 cents per pip or something). So, in order to make serious money through small changes, you need to trade big – capitalize on even the tiniest changes. In order to trade these gargantuan sums of money, leverage is simply a must. Which is fine, until you lose.
Leverage may be a useful tool, but also needs be used wisely. It would be subjective to call it good or bad a priori. The best you can hope to do is to make an informed decision. Hopefully, this article helped.