Leverage generally means borrowing money. Leverage is used not only to acquire physical assets such as real estate or cars, but also to trade financial assets such as equity and foreign exchange (“forex”).
Trading forex by retail investors has grown tremendously in recent years. The development of online trading platform and the availability of credit also triggered the popularity of forex trading. The use of leverage in trading is often equated with a double-edged sword, because it enlarges profits and losses. This happens in the case of forex trading, where high leverage levels are normal.
The following example will illustrate how leverage enlarges profits or losses in a profitable and unprofitable trading.
If you are an investor based in the United States and have an account with a particular online forex broker. Your broker gives you the maximum allowable leverage in the US on a pair of major currencies (pairs) of 1:50, which means that for every dollar you use you can redeem $ 50 from the major currencies. For example you want to use $ 5,000 as margin, which is a guarantee or equity in your trading account. This implies that you can place a maximum of $ 250,000 ($ 5,000 x 50) in a currency trading position initially. This amount will obviously fluctuate depending on the profits or losses you generate from your trading. (To keep it simple, we ignore commissions, interest and other fees in this example.)
Example 1: Buy USD / Sell Euro. Trading amount = 100,000 EUR
Assume you start trading with the above example when the exchange rate is 1 EUR = 1.3600 USD (EUR / USD = 1.36), because you expect the European currency to decline in the near future.
Leverage: Your leverage in this trade is just above 1:27 (136,000 USD / 5.000 USD = 27.2, to be exact).
Pip Values: Because quotations of the euro use four numbers after decimal, each “pip” or base point moves in euro equal to 1/100 of 1% or 0.01% of the traded amount of the base currency. The value of each pip is expressed in USD, because this is the counter currency or quote currency. In this case, based on the amount of currency traded at 100,000 EUR, each pip is worth 10 USD. (If the traded amount is 1 million EUR versus USD, each pip will be worth 100 USD).
Stop-loss: When you test the market with regards to forex trading, you set a stop loss of 50 pips at the position Buy USD / Sell EUR. This means if the stop loss is triggered, your maximum loss is 500 USD.
Profit / Loss: Fortunately, you have good luck as a beginner and the euro goes down to level 1 EUR = 1.3400 USD within a few days after you start trading. You close the position for a profit of 200 pips (1.3600 – 1.3400), which means 2,000 USD (200 pips x 10 USD per pip).
Forex Math: Conventionalally, you sell 100,000 EUR and receive 136,000 USD in your opening trade. When you close the trade, you buy back the euro you have sold at a lower price of 1.3400, paying 134,000 USD for 100,000 EUR. The difference of 2,000 USD is your gross profit.
Effect of Leverage
By using leverage, you can generate a 40% return on an initial investment of 5,000 USD. What if you only redeem 5,000 USD without using leverage? In this case, you will only sell euro equivalent to 5,000 USD or 3,676.47 EUR (5,000 USD / 1.3600). The number of transactions is significantly smaller than each pip which is only worth 0.36764 USD. Closing the euro sell position at 1.3400 will result in a gross profit of 73.53 USD (200 pips x 0.36764 USD per pip). Using leverage, magnify your profits appropriately 27.2 times (2,000 USD / 73.53 USD), or the amount of leverage used in trading.