Leverage is probably the one characteristic of the forex market that intrigues individual investors the most. Leverage is the ability to convert a small amount of power into a larger amount through the use of a tool. Imagine you are asked to move a large boulder from the spot where it is currently resting. You could certainly try to push and move the boulder with your bare hands, but your job will be much easier if you can use a tool—like a large pole—that you can place under the boulder that will give you some leverage.
The same principle holds true when you are investing in the forex market. You can make money by investing just your own money, but you can make much more money if you can use the tool of financial leverage by borrowing money from your dealer.
You can lever, or increase the investing power of, your forex accounts by using some of your own money to enter a trade and then borrowing the rest from your dealer. For example, the forex market allows you to control $100,000 with as little as $1,000 of your own money. That means you only have to pay for 1 percent of the position with your own money. You can borrow the remaining 99 percent of the purchase price from your dealer.
The leverage you enjoy in the forex market is determined by the margin you are required to post for each trade.
The forex market is an exciting market because your dealer is willing to lend you money so you increase your profit-generating potential in all of your trades. Before your dealer lets you borrow money, however, you have to show that you have some money to cover any losses you may incur. Margin is the money you set aside with your dealer for safe keeping to prove that you are able to cover your losses.
For example, if you buy the EUR/USD, you will be required to set aside 1 percent of the position size as margin. That means if the position size is 100,000 euros, you will be required to set aside the equivalent of 1,000 euros to prove to your dealer that you can cover losses of at least 1,000 euros should your trade move against you.
Different currency pairs have different margin requirements. Major currency pairs have lower margin requirements because their high levels of liquidity make it easier to enter and exit your trades quickly—which gives your dealer added confidence it will be able to close out your positions without incurring unexpected losses. Exotic currency pairs have higher margin requirements because their low levels of liquidity make it harder to enter and exit your trades quickly.
Many beginning forex traders get confused by thinking that the money they set aside as margin actually goes toward purchasing currencies. It does not. You borrow 100 percent of the purchase price from your dealer. Your margin only shows your dealer you have money to cover any losses that you may incur.
When you buy a currency pair, you do not have to come up with the cash on your own. Your broker loans you enough of one currency to buy enough of the other currency in the pair. For example, if you click on the “Buy” button to buy the EUR/USD pair at 100,000 units, your dealer will loan you enough U.S. dollars (USD) to buy 100,000 euros (EUR). If the EUR/USD exchange rate is 1.4000 at the time, your dealer will loan you 140,000 U.S. dollars to buy 100,000 euros.