How Does FX Market Leverage Work?

If you are new to the concept of currency trading, you might be a little bit confused as to what this “leverage” feature is all about. Most brokerage companies all offer generous leverage, and they promote this as a major feature of their offerings. For example, it is not unusual to see 200:1 being quoted by many of the large FX trading companies these days.

Because of the nature of Forex trading, you need a lot of money to actually make a realizable profit or loss. This can be easily seen in the following example:

Trader 1 has $1,000 and is trading with 1:1 leverage. This means that for every 1 pip movement in the currency market, they will only be able to realize a profit or loss of $0.01 for each pip. They would need a huge amount of money to make realistic profits in this market.

As you can see, this trader who has only 1:1 leverage is at a major disadvantage. They have to wait for a HUGE swing in the Forex markets to even make a small $10 profit!

An Example with Leverage

Now, let’s say that the person in our example places their $1,000 with a company which offers 200:1 leverage. Whilst they only have $1,000 physically in their account, they now have borrowing and buying power of 200 x $1,000 – which is $200,000.00.

This means that they are now able to buy and sell up to $200,000.00 worth of currency, and then realize the profits and losses from this larger trade.

If the trader entered a trade for even half of this – say $100,000 – they would be looking at a $10 profit or loss for EVERY 1 pip that the currency moved.

Hence – take a look at this numerical display:

• Trade amount of $100,000 (1 standard lot)
• Currency moves 20 pips in the course of a day in favour of the trade
• Trader has made $200.00 profit for the day
• New balance in the account of $1,200.00

 

As you can see, this trader has made a 20% return on their cash within just one day – with money that they don’t actually own.

The Risks of FX Leverage

We just showed you how FX leverage can be beneficial to a trader. However, it can also work against you if you choose the wrong side of a trade. A $200 profit could quickly turn in to a $200 loss, and for that reason we recommend you use leverage properly to avoid issue and over-loss.