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When most people think about investing they think that they need large amounts of initial capital in order to start.
While this may be the case for stocks, bonds and other investments, forex is much more accessible due to the use of leverage. So how does leverage affect your trading?
To explain, think of buying a home. You may want to buy a property that is worth one hundred thousand dollars, so you go to a bank to take out a loan or mortgage. The bank requests that you supply twenty percent of the property as a down payment on your loan. So, for twenty thousand dollars, you are now able to enter into ownership of a one hundred thousand dollar home.
This is an illustration of leverage in real estate.
You have bought the home at a leverage of five to one, since twenty thousand dollars is one fifth of one hundred thousand dollars.
One year later the property market has appreciated by fifty percent and you decide to sell the property for one hundred and fifty thousand dollars, making a fifty thousand dollar profit.
If you had not taken out a bank loan and had used only your twenty thousand dollars to buy a small studio which cost that amount, your total profit after a fifty percent property price increase would have been only ten thousand dollars.
Your five to one leverage has allowed you to earn five times more than you would have if you had traded without leverage.
Let's see how we can apply leverage to a forex deal.
You currently have one thousand Euros to invest and you decide to buy one hundred thousand EUR worth of EUR/USD, at a rate of one point thirty-one thirty. Since one thousand is one hundredth of one hundred thousand, you are using a leverage of one hundred to one.
The EUR/USD rate then moves up to one point thirty-one forty and you decide to close your deal, making a ten pip profit.
Using the pip formula from the 'What is a pip video,' you can calculate that your total profit is one hundred dollars. If you had not traded with leverage you would have only made a one dollar profit.
In fact, depending on your account type and risk preference, you can trade much smaller or larger deal sizes, and use different levels of leverage.
It is important that you keep in mind that higher leverage can increase your potential profits, but it can also lead to bigger potential losses. Due to this risk, we encourage traders to plan their trades well by making sure they employ a risk management strategy and keep learning about the market.
To improve your trading skills further, you can visit the Learn section of our website where you can explore the rest of our educational tools such as our eBook, and sign up for our online webinars