Potential (and Risks) of Leverage
You probably know that in forex trading there's potential to make profits far greater than you'd think possible considering the amount of capital you have at your disposal. What facilitates such great potential for profit is leverage. Leverage may help you make large profits but it also raises the risks. This is why it is important to know just what leverage is and how it works.
Trading In Larger Sums than You Actually Possess
Leverage in essence is trading in sums that you do not actually have. In forex, leverage may mean having just 1000 dollars but using them to trade on 100,000 euros. This is how it works- If the exchange rate for USD to Euros is 1.5221 you can only buy 657 Euro with 1000 U.S dollars. Thanks to leverage even if your whole bank role is just 1000 dollars you can still trade on 100,000 Euros just as if you had used 152,210 U.S dollars to buy them, all you need is a leverage of 153 (sometimes leverage rates may be as great as X400).
If the exchange rate rises by 100 pips to a 1.5321 level, when you end the trade 100,000 Euros will be worth 153,210 U.S dollars. This means a profit of 1000 U.S dollars, you'll end up doubling your investment, a profit of 100% which may have been gained in the course of just one day! However, if the spread ends up at a negative 100 pips the loss amounts to 1,000 U.S dollars, in such a case leverage has made you lose all of your capital.
To Leverage Or Not To Leverage?
Now that you know what forex leverage is and realize you can use even small sums to make large scale trades you may feel highly inclined to do so. It is very important to remember that if your capital is limited and you use leverage on a trade that does not end well you may very well lose your entire bank role on just one trade making it very hard for you to keep on trading and earning back your loses. An important tool which will help you decide whether to use forex leverage or not is the forex leverage computer, by typing in the sum you have and the trade you wish to carry out you'll find out just how much you stand to gain or lose thus allowing you to make a more informed decision.
If you're wondering why leverage is made possible the answer is simple, larger sum trades mean larger commissions. Using forex leverage to make a 300,000 Euro trade means that a 3 pip spread (which constitutes the commission paid) may amount to 100 U.S dollars. In comparison, on a 3,000 Euro trade (one the trader may only be able to afford without leverage) the 3 pip forex spread commission will amount to just 1 U.S dollar.