Leverage is a type of interest-free loan put up by a broker. You can use leverage in trading to maximize the size of your position, and so, increase the returns.
Also, you can use leverage to minimize margin (the collateral demanded by the broker for the position opened).
In this article, you will learn what is leverage and how it works. You will also get an idea about, how to calculate and find out the most optimal leverage.
However, This article will work as a guidebook and will cover all the pros and cons of leverage trading.
Now, let’s jump to the main portion!
What is leverage? Leverage Definition & Meaning
Assume that you buy apples in the wholesale market in a big city and sell them in a local market in a small town. It is clear that you have a certain extra charge for providing the service of moving apples from the wholesale market to the small town.
Therefore, the more apples you can buy in the wholesale market, the more you will earn on the markup (provided that all the apples are sold out).
But you have a limited amount of cash. You understand that you can sell 5 times more apples in the local market, and you go to a bank to take a loan.
Forex leverage explained in simple terms is a kind of bank loan provided by the broker to the forex trader. If you have a relatively small deposit and use the leverage, you can buy several times more currency or stocks, and so, make several times more profit.
What is Leverage in Trading: Forex?
Firstly, there is a marginal difference between a bank loan and forex leveraging. A forex trader can use leverage at any time for no cost, the broker provides the loan with no interest charged on the amount of debt.
Financial leverage in FX trading is:
- An option that allows a trader to enter trades with a volume several times larger than the actual amount of money on the trading deposit.
- An instrument of margin trading, which is the funds you borrow to increase the position volume, and so, to increase your profit, in case your equity is not enough.
- The ratio between your deposit and the position volume you are opening.
The maximum Forex leverage is specified in trading conditions for each type of trading account. For instance, the maximum leverage for one account is 1:200; for another account, it will be 1:1000.
Which leverage is the safest? The minimum allowable leverage is 1:1.
There is no upper limit, in theory, that is why you can come around the Forex leverage of 1:3000.
However, financial regulators highly recommend brokers lower the maximum limit of leverage to lessen the risk of losing the trader’s deposit.