What is leverage?
In simple terms, leverage refers to using a small amount of one thing to control a large amount of something else. Specific to Forex trading, leverage is the borrowing of capital to increase your returns on investment. It means that you can have a small amount of capital in your account but control a much larger amount in the Forex market. Since nothing is better explained with an example, here we go:
If a Forex broker offers you a leverage of 100:1, this means that for every $1 you have in your account, you can place a trade worth $100. So if you have $1000 in your account, you can control a $100,000 position.
Similarly, for a leverage of 500:1, you can place a trade worth $500 for every $1 in your account.
The concept of leverage also ensures that even traders with little capital to invest can place significantly larger traders and get higher returns on their investment. But leverage works in two ways, and losses can mount in a hurry when a trade goes wrong. We’ll get back to that a little later.
How leverage works?
If a trader has $1000 in his account, and a leverage of 100:1, he can trade a position that is as large as $100,000, or 1 standard lot. Now let’s say that the $100,000 investment rises in value by $1000 i.e. $101,000.
Now without leverage, the trader would have had to invest the entire $100,000 which would have resulted in a rather meager return of 1%. Since he is leveraged 100:1, the trader has only invested $1000 and has a big return of 100%. This is where leverage works its magic. It magnifies your gains substantially. So it makes sense to open a trading account with the highest leverage. Or does it?