The principle of the leverage effect on the Forex:
The online brokers that enable investing on the Foreign Exchange market offer their clients the opportunity to benefit from a leverage effect. This tool actually enables you to speculate with more money than you actually have as capital in order to make increased profits.
There are various levels of leverage effect available that generally range between 1 : 100 and 1: 400. A leverage effect of 1:100 means that your investment on a currency pair is multiplied by 100. But where does this money come from? Simply put, it is the broker that lends you this money for ‘free’.
Why the leverage effect is necessary when trading on the Forex:
To understand the point of using the leverage effect when trading on the Forex, you should understand that the variations in the rates between the currency pairs are often quite small compared to other assets such as stock market shares. Without a leverage effect, it would be very difficult to achieve profits, even if you hold a substantial investment capital.
Course of action concerning the risk related to the Forex leverage effect:
Of course, the higher the leverage effect, the higher the potential profits. However this advantage cuts both ways as the amount of any losses you incur is also multiplied by the same factor.
As we have just shown, it is therefore important to use the leverage effect prudently and carefully as any losses are also impacted by this tool. With a leverage effect of 1 : 100, the amount of your losses would also be multiplied by 100.
If we return to our previous example and then imagine that our currency pair EUR/USD changes from 1.25 to 1.24 pips you will therefore lose €1 without the leverage effect and €100 with it. The higher the leverage effect the more money you risk losing.
We can summarise the leverage effect risk in the following manner:
- With a leverage effect of 1 :100, if the currency pair upon which you are speculating loses 100 pips then you lose your entire investment in it, which rarely happens on the Forex.
- With a leverage effect of 1 : 200, it simply requires a difference of 50 pips to lose everything you speculated on that transaction.
- And with a leverage effect of 1 : 400, it simply requires a difference of 25 pips for this to happen.
It is therefore generally advisable to use a minimum leverage effect to reduce the risks.