What is the leverage effect on the Forex

Post by : Sam Allcock on 18.01.2021

One of the main advantages of trading on the Forex is the effect particular to the foreign exchange market known as the ″leverage effect″. To help you better understand the advantages and use of this leverage effect here is some explanation on its functions and utilities.

What is the advantage of trading with a leverage effect?

This leverage effect is in fact a precious advantage that cannot be found on the other stock and financial markets as it enables good returns on sizable investments.

To explain clearly, when you conduct margin operations on the Forex (also called leverage effect operations), you do not necessarily have to invest the entire amount yourself in the transaction.

Due to this leverage effect, you can hold superior positions compared to the real amount of your investment. Certain CFD trading platforms even offer you the opportunity to go up to 400 times your initial investment although the majority of effects offered are either 1:100 or 1:200.

Why is the leverage effect particular to the Forex?

This particularity to the Forex can be explained due to the small variation in rates (degree of volatility) that rarely exceeds 1%. With the stock markets this variation is generally around 5-10%.  This is what makes the Forex market one with a strong leverage effect, by definition.

We can better understand the leverage effect by analyzing the profits possible if we invested several thousands of Euros. With variations of one cent already considered as a significant movement it does not easily allow the possibility of making remarkable profits.

The leverage effect therefore makes it possible to increase the stakes and therefore the possible profits without having to invest several hundred thousand Euros. This is what makes it a less accessible market.

Note that it is very difficult to conduct a transaction of less than €100,000, the currencies are exchanged in lots, even though some brokers offer smaller lots in order to enable individuals the chance to also profit from the currency exchange rates.   

The leverage effect: How does it work?

To better understand the use of the leverage effect with the Forex, here is a concrete example using this tool:

If you have €1,000 available you can purchase a lot of 100,000 EUR/USD. In fact, by using the leverage effect of 100:1, this comes down to multiplying your margin account of €1,000 by 100.

In this precise case, if the lot that you purchased was quoted at the beginning at 1.5270 and you resell at 1.5500, your profit will not be €23, it will be €2,300.

In the opposite situation, if the rate of the lot decreases to 1.5200, the loss incurred will therefore be €700.

The precautions to take when trading with the leverage effect

When using the leverage effect, you multiply your investment and therefore your potential profit by a high coefficient. However, this leverage effect should be used intelligently by respecting certain precautions in order not to lose too much money.

For example, if you lose 60 pips on your lot and your margin account does not have the funds to cover the eventual loss, the broker will launch a margin call that requires you to renew your cover by adding the funds necessary to your account. If necessary, he will close your account and you will lose 50% of your initial capital. It is therefore of primary importance that you manage your strategy well keeping in mind this leverage effect, for example by using several orders simultaneously (If Done or OCO orders).

Important Note

The margin and the leverage effect are two interdependent items. In fact, the margin is used, when you are trading on the Forex(we recommend to do this on https://www.tradedwell.com/ ), as a guarantee when you make a transaction with the leverage effect. The rate of this margin is determined according to different criteria as directed by the agent. These are what we call the margin conditions.

Due to this defined margin you can create a leverage effect on a transaction. To summarize, the amount of your margin decides the value of your leverage effect and the leverage effect itself also determines your margin.

Conclusion

The leverage effect should therefore be used with caution as although it can allow serious profits it also incorporates serious risks. It is therefore recommended to start trading using small leverage effects with the aim of testing the market. If you find that the market moves in your favour all you have to do then is increase this leverage effect.

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