Lots of people new to trading get confused by the concept of leverage in Forex, how it is calculated and how it should be used. If you are just starting out trading, you should approach leverage with caution because this very powerful tool can also work against you.
The Basic Concept:
A standard trading account with a regular broker will usually deal in lots of $100,000. To make a single trade with your account, you need $100,000 to place on it. This figure is beyond the reach of most of us, and so this is why brokers offer leverage.
To allow people to trade these large lot sizes, brokers will effectively loan you money to place the trade provided you give them a percentage of the trade as a security against it. If the trade falls by more than you put up as collateral then the broker will close your trade and that money will be lost, but if the trade moves in your direction then you stand to make a good profit.
More Details On Leverage In Forex:
You will usually see brokers advertising leverage in the form of 2 numbers separated by a colon, e.g. 100:1. In this case, the figures mean the trader is willing to let you trade with only 1% security. Similarly, 200:1 means they are offering trades with only 0.5% security (1 / 200 * 100) and so on. You may see brokers go as high as 400:1 (0.25%).
You may also see the word 'margin' used when leverage in Forex is talked about. The margin is always expressed as a percentage, and it is the figure that represents the percentage of the trade required as security. In the case of 100:1 leverage, the margin is 1%
Leverage In Use:
You can see now that by using leverage in forex trading, you can typically control a trade of $100,000 by only risking $1000 yourself, because the broker loaned you the other $99,000. As mentioned previously though, your trade will get closed by your broker if it falls by the $1000 security you used. This is because the broker is protecting himself from a loss on your trade.
Because you traded with a 1% margin, you couldn't afford your trade to drop by more than 1%. Due to the volatile nature of the market, it is entirely conceivable that a trade with a good probability of turning a profit will move in the wrong direction by 1% or more first. Your small margin for error meant you lost your stake because your broker had to close the trade too early, this is commonly referred to as being too heavily leveraged.
