How Forex Leverage Works

Investing in the foreign exchange market, or rather the Forex market, is a great way of expanding business and the possibility of getting better returns. In Forex trading, leverage can be a double-edged sword, while it can significantly increase an investor's gain potential, leverage can also increase your loss potential.
WealthHow Staff
In the world of finance and commerce, the 'word' leverage implies a technique to increase or multiply the returns on investment for a particular investment or set of investments. In some cases it also implies the increasing of equity or net worth of a business. Though the term is broad and covers several different assets, business and investments, a Forex leverage is basically a method or a set of methods, which are used to increase the net worth or realizable value of an asset or the returns of a certain investment. Leverage is conventionally achieved with the help of borrowings, contracts or debts. In case of Forex leverage, the credit or loan for the process is provided by the Forex brokers.

It must be noted that the theory, facts and mechanism of Forex leverage tends to sound surrealistic and almost like a bluff, however, that is the way it works.

What is Leverage

To understand how Forex leverage works, one needs to understand how Forex trading works and the meaning of PIP and BP. Here's a quick reminding illustration of the same.

When you invest money in market such as a money market, stock market or in this case, the Forex market, there are three kinds of benefits or profits which you can reap, if the investment is done thoughtfully, logically and in a well analyzed, reasoned and calculated manner. The first one is the sale value profit, which is basically obtained from selling the owned investments at very high price from the price at which it was purchased. The second type of benefit is the period return that you receive from the investment such as dividends on shares/stock. The last one is broadest and is commonly known as total return on investment. This is the total and overall gain you have made from the investment. This amount is the cash or non-cash and may be realizable or unrealizable. With the help of Forex leverage, what we do is, increase the total amount that you hold in the Forex market in some other currency. There are two prominent ways with the help of which this can be done.
  1. The first step is to open a marginal account with the broker when you are dealing in Forex. Then you can borrow, some money from the broker to invest in some other 'quote currency'. There is of course, a minimum amount you have to personally put in, before which the broker does not sanction the loan. The loan sanctioned is usually expressed in a ratio such as 5:3 or in percentages such as the 60%. The latter number or the percentage is the amount which is invested by you into the marginal account. It is basically your own investment. In this case, the broker will be loaning you 40% of the total investment. The 40% loan is your leverage.
  2. Now the second method with the help of which you can opt for Forex leverage is by using derivatives. Derivatives are contracts wherein you as an investor has the right, but not the obligation, to purchase a currency at a predetermined price. Now this type of contract considerably increases the value of asset which you are holding whereas you actually invest or quote less. Note that a careful study is required to exercise the right properly.
In most of the cases instead of using just the derivatives, brokers make it a point to invest both ways, as it wards off unwarranted risks.

PIP: Price Interest Point
It indicates the 4 figures that follow the decimal.

$1,000.0000

A rise of 4,000 in the PIP means that the quote currency has risen and is indicated by: $1,000.4000
BP: Base Point
It indicates the 4 figures that precede the decimal.

$1,000.0000

A rise of 4000 in the BP means that the quote currency has risen and is indicated by: $4000.0000

Note: Info in the table assumes that the base currency is the USD (United States Dollar)

Forex Leverage: Practical Application

The practical application of Forex is known as margin based leverage after the marginal account wherein you invest your money. The leverage or rather the loan which is provided by the broker has the following formula.

Leverage (Margin Account) = Total Value of Investment/Asset/Transaction (-) Required Margin/Minimum Balance in account

Now, such a leverage is often expressed in percentages or ratios. For example, a 50:1 ratio means that 2% of the total asset/investment value is your marginal accounts balance, which is your money. The remaining $49 is of course, the loan by your broker. That is to purchase $50 worth of foreign currency you need to put in, at least, $1 following which the lender loans you $49. Sometimes this sounds almost unreal however, the very small rises in the PIP and BP lead to profits, which are quite significant, and hence, the large loan by the broker. Either ways, the broker is always at advantage even if you lose money. One needs to remember that a leverage is a loan and a fee and interest is charged upon it through your marginal account.

Some people question how the profit is distributed. Well, the trend often differs from broker to broker and also country to country. The usual trend goes that the broker charges a nice hefty fee and percentage and the total amount lent i.e. $49 as in the above case is returned to the broker. The remaining profit is enjoyed by the investor that is you. Please note that there are some strict compliance regarding the balance in the marginal account and the ratio or percentages of the leverage.