What is Leverage?

Let’s assume that you are an investor based in the U.S. and have an account with an online forex broker. Your broker provides you the maximum leverage permissible in the U.S. on major currency pairs of 50:1, which means that for every dollar you put up, you can trade $50 of a major currency. You put up $5,000 as margin, which is the collateral or equity in your trading account. This implies that you can put on a maximum of $250,000 ($5,000 x 50) in currency trading positions initially. This amount will obviously fluctuate depending on the profits or losses that you generate from trading. (To keep things simple, we ignore commissions, interest and other charges in these examples.)

Example 1: Long USD / Short Euro. Trade amount = EUR 100,000 Assume you initiated the above trade when the exchange rate was EUR 1 = USD 1.3600 (EUR/USD = 1.36), as you are bearish on the European currency and expect it to decline in the near term.

Leverage: Your leverage in this trade is just over 27:1 (USD 136,000 / USD 5,000 = 27.2, to be exact).

Pip Value: Since the euro is quoted to four places after the decimal, each “pip” or basis point move in the euro is equal to 1 / 100th of 1% or 0.01% of the amount traded of the base currency. The value of each pip is expressed in USD, since this is the counter currency or quote currency. In this case, based on the currency amount traded of EUR 100,000, each pip is worth USD 10. (If the amount traded was EUR 1 million versus the USD, each pip would be worth USD 100.)

Stop-loss: As you are testing the waters with regard to forex trading, you set a tight stop-loss of 50 pips on your long USD / short EUR position. This means that if the stop-loss is triggered, your maximum loss is USD 500.

Profit / Loss: Fortunately, you have beginner’s luck and the euro falls to a level of EUR 1 = USD 1.3400 within a couple of days after you initiated the trade. You close out the position for a profit of 200 pips (1.3600 – 1.3400), which translates to USD 2,000 (200 pips x USD 10 per pip).

Forex Math: In conventional terms, you sold short EUR 100,000 and received USD 136,000 in your opening trade. When you closed the trade, you bought back the euros you had shorted at a cheaper rate of 1.3400, paying USD 134,000 for EUR 100,000. The difference of USD 2,000 represents your gross profit.

Effect of Leverage: By using leverage, you were able to generate a 40% return on your initial investment of USD 5,000. What if you had only traded the USD 5,000 without using any leverage? In that case, you would only have shorted the euro equivalent of USD 5,000 or EUR 3,676.47 (USD 5,000 / 1.3600). The significantly smaller amount of this transaction means that each pip is only worth USD 0.36764. Closing the short euro position at 1.3400 would have therefore resulted in a gross profit of USD 73.53 (200 pips x USD 0.36764 per pip). Using leverage thus magnified your returns by exactly 27.2 times (USD 2,000 / USD 73.53), or the amount of leverage used in the trade.

What is the most I can loose with leverage?

Whatever amount you deposit into your account is the maximum you can loose. Even though the broker is providing you with large amounts of leverage, brokers will never loose the amount they provide due to margin calls. If your account goes into margin call (when your trades move significantly against you), the trading platform will automatically close all open trades so the broker is never at a lose.