Leverage is an investment strategy where you can trade with a small portion of your own capital while borrowing the rest. In retail FX trading, where traders use CFDs (Contracts for Difference) to trade currency pairs, brokers will set aside, for example, just 1000 USD to allow you to control a position equivalent to 100,000 USD. This means that your leverage is 1:100 as you can control as position size of 100,000 USD by committing only 1000 USD which represents your margin. This is often referred to as “trading on a margin”.
For example, if the EUR/USD exchange rate is 1.1000 and you choose leverage of 1:10, you would only need to put up 1/10 of the investment (let’s say it’s EUR 10,000) as your margin, which is EUR 1000. If the EUR/USD is trading at 1.1000 (USD 1100), for an investment of 10,000 Euros, a 1:100 leverage would mean that the amount you would have to commit (the margin required) would be EUR 100 or USD 110.
If you used even higher leverage such as 1:500, your margin requirement for a 10,000 Euro investment would be only EUR 20 or USD 22. However, it is important to understand that leverage is like a double-edged sword. The advantage is that it allows you to make much higher returns, as the amount you commit from your own funds is much smaller than the total investment size. On the downside, even a small price movement in the opposite direction of your trade can lead you to lose the entire amount you’ve committed.
Now, let’s assume that the exchange rate of EUR/USD increases from 1.1000 to 1.1100. If you close your position, your profit would be 100 USD. This is because it represents the difference between the contract’s exchange rate at 1.11 and the opening price of 1.10, which is a movement equal to 0.01 multiplied by the investment size which was 10,000. This results in a profit of 100 USD. With a leverage of 1:1, practically no leverage, instead of 1:100, your profit margin would be slightly less than 1%. However, with a leverage of 1:500, your profit margin increases to approximately 455%, much higher relative to the amount you invested.
It’s important to understand leverage as a magnifying glass. A small price movement in your position can result in a big change in your profit or loss. Nonetheless, the risk associated with leverage should not be underestimated. The higher the leverage, the higher the risk. Therefore, the decision regarding the level of leverage to use should be solely the responsibility of the investor as they will take all the risks.
