Leverage and its Risks
Updated: April 17, 2013 at 5:08 AM
Leverage can be defined as the amount of a trading position you can control with a given amount of margin, i.e. money placed on deposit as collateral. Also, the leverage ratio is the ratio of that amount of leverage to the amount of margin.
In practice, a leverage ratio of 50:1 would mean that you could control $50,000 worth of a position with just $1,000 on deposit as margin.
While professional forex traders generally trade using the credit lines that banks and their counterparties extend to each other, retail forex traders have to master this concept of leverage since they are usually required to trade on margin rather than credit.
Forex Positions Have No Initial Value
Part of the reason that leverage ratios can be so high in the forex market is that forex trading positions have no net initial value. It therefore is not the same as a purchase or sale of a tangible item such as a commodity or a stock.
This is because a forex position initially consists of an exchange of assets of equivalent value in the form of different currencies.
Therefore, when a position is established in the currency market, no money theoretically needs to be exchanged to pay for it because the position has no net initial value.
This explains why most banks trade on credit lines, but retail forex brokers insist that their less creditworthy customers put up margin to cover potential losses on each forex transaction.
The Risks of Leverage
Naturally, this high leverage ratio can act as a two edged sword, since losses can accumulate as quickly as profits on larger positions. Nevertheless, if you have accurately called the direction of the market, you stand to make good money on your rather small initial investment.
Furthermore, traders need to keep close track of their margin requirements for open forex positions since many retail forex brokers will simply close out losing positions when a situation arises where the margin in the trading account has been used up due to adverse market movements.
Look at this video explaining what leverage is. Provided by Easy Forex.
Risk Statement: Trading Foreign Exchange on margin carries a high level of risk and may not be suitable for all investors. The possibility exists that you could lose more than your initial deposit. The high degree of leverage can work against you as well as for you.