The textbook definition of leverage is having the ability to control a large sum of money using none or very little of your own money and borrowing the rest.
In forex trading, it is defined as an act of using borrowed money to increase earning potential.
To put it simply, leverage is essentially borrowed money provided by a forex broker to get involved in potentially high-profit trades without having to invest vast swathes of your own capital.
Fun fact: Trading was traditionally reserved for society’s elite who could afford to come up with large amounts of capital. Traditionally, $50,000 had to be invested as a starting capital.
$50,000 for a $50,000 investment. This is called 1:1 or no leverage.
Fortunately, it is now 2020 and you’re not leveraged 1:1, you’re leveraged anywhere from 3:1 all the way up to 500:1.
Leverage of 100:1 means you can trade a notional value 100 times greater than the capital in your trading account.
For example, to control a $50,000 position, your broker will set aside $500 from your account and you can control $50,000 with $500.
Let’s take GBP/USD as an example…
Without leverage, opening a 1 lot trade (100,000 units)would require a trader to invest around $127,000.
Using leverage of 500:1, we can dramatically reduce the amount of capital required.
$127,000 / 500 (leverage used) = $254.00 required capital
Using this leverage size, we can use a simple formula to work out the amount of investment needed:
Buy trade: Ask price x contract size / leverage
Sell trade: Bid price x contract size / leverage
1 lot = 100,000 contracts (contracts worth is based on the base currency which in our case is GBP)
Understanding leverage enough to know when to use it and when not to is critical to forex trading success.
And don’t get fooled by the broker’s favourite selling point – high leverage.
Yes, you can make a huge killing using huge leverage, but also know that you could easily be killed by huge leverage as well.
What do I mean by that?
When leverage works, it significantly magnifies your profits. Your head gets BIG and you think you’re the greatest trader that has ever lived.
But there’s a catch. Leverage can also work against you.
If your trade moves in the opposite direction, leverage will amplify your losses.
You’ll be broke faster than Carole Baskin fed her husband to the tigers.
Here’s a chart of how much your account balance changes if prices move depending on your leverage.
My advice? Be realistic in your expectations and don’t start trading with real money and huge leverage.
Play it safe. Protect your capital.
If you don’t, you will die.
Okay, not you, but your account will.