How Forex Leverage Works

Using leverage in the Forex market is the same, in concept, as any other type of investment because the strategies used are meant to increase returns. Most investors use such things as options, margin accounts and perhaps futures to lever investments, and Forex leverage is quite similar except margin accounts are the norm. In examining how Forex leverage works it will become evident just how important the role of the broker is in the strategy.

Using Leverage to Raise Capital
Actually, companies use leverage to raise capital without issuing stocks. In other words, leverage can be considered to be a sort of debt financing in order to raise the necessary operating funds without borrowing against assets. In the Forex market leverage is a type of loan that the investor receives from the broker in order to realize profits from exchange rate fluctuations. This type of leverage is called setting up a margin account wherein the investor only needs to deposit a certain percentage of the amount he or she would like to invest in Foreign Exchange and the broker ‘loans’ the investor the remaining amount.

Forex Margin Account Basics
The most common Forex leverage account is either a 50:1 or 100:1 which means that the trader needs to deposit $1 for every $50 or $1 for every $100 traded respectively. However, there are also 200:1 margin accounts as well that are quite common. In a 50:1 margin account the investor is putting up 2% of the investment and the broker would finance the other 98%. Likewise, in a 100:1 account the Forex trader places $1 for every $100 traded in the margin account while the broker loans the other 99%. Since investments are usually made in currency units of 100,000 at a time it is understandable how important the Forex trader’s credit is.

Setting up a Margin Account with a Forex Broker
When first investing in the Forex market the first thing an investor does is to set up a margin account with a Forex broker. The amount placed in the account depends on the leverage. For example, to trade the standard currency unit of $100,000 the investor would need to place $1,000 in the margin account with the broker. When the margin account is established the trader will probably want to use a strict style of trading in order to minimize potential losses.

Advantages and Disadvantages of Forex Leverage Accounts
In understanding how Forex leverage works the first thing to realize is that it is a two sided coin (no pun intended). The advantage is that there is a potential to realize significant gains but the flip side of the coin is that you can also magnify the potential for loss which is a definite disadvantage. For instance, if the underlying currency should happen to move in the contra to the direction in which you thought it would you can lose significant amounts of money, especially on a 100:1 margin account. It is simply for this reason that you aren’t likely to see leverages of 15:1 that is commonly used in the futures arena.

A basic understanding of how Forex leverage works is essential when trading in Foreign Exchange since the standard trading unit is so high. The only real decision should be which broker to set up your margin account with. Since some will provide leverage at 100:1 while others will offer leverage at 50:1 you can shop around a bit to get the leverage you desire. Keep in mind that there are some who offer leverage at 200:1 but usually those margin accounts are only established for less commonly traded 50,000 currency units.

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