Leverage is a tool that allows an investor to increase the volume of transactions through the use of borrowed funds. This practice is common in the forex market, where traders may borrow money from a broker to trade larger currency positions.

Using leverage increases your potential profit from favorable exchange rate movements. However, it is important to understand that leverage is a dual-effect tool that can also magnify losses. Successful use of leverage requires the trader to be able to manage risk. To mitigate potential losses in foreign exchange markets, it is necessary to use risk management strategies.

We talk about the mechanism of how leverage works.

How leverage works

Let us remind you that the Forex market is the world’s largest decentralized financial market, where currency exchanges amounting to more than $5 trillion are carried out daily. Forex trading involves buying and selling currency pairs in order to change the exchange rate in favor of the trader.

Forex exchange rates are quoted in the form of bid and offer prices provided by the broker. The bid price is used when opening a long position (buying a currency), and the ask price is used when closing a position (selling a currency). For example, a trader buys the euro against the US dollar (EUR/USD) in the hope that the exchange rate will rise. EUR/USD is purchased at the bid price, for example, $1.10. If the EUR/USD exchange rate changes favorably, the trader closes the position by selling the same amount of EUR/USD to the broker at the offer price. The difference between the buying and selling rates is the profit (or loss) from the transaction.

Traders use leverage to increase potential profits from forex trading. Leverage is essentially a loan provided to an investor by a broker. A trader’s Forex account is created to allow trading using margin or borrowed funds.

Some brokers may limit the amount of leverage for new traders. In most cases, traders can tailor the amount or trade size depending on the leverage they want. However, the broker will require that a certain percentage of the notional transaction amount be kept in the account in the form of cash – this is called the initial margin.

Leverage risks

Although the potential for significant profits is attractive, the use of leverage can backfire on investors. So, if the exchange rate of the currency underlying the transaction moves against the forecast, leverage significantly increases the potential losses.

To prevent catastrophic consequences, forex traders adopt a trading style that involves the use of stop loss orders, which is a trading order to a broker to close a position at a specific price level. In this way, the trader limits possible losses from the transaction.

Leverage can be an effective tool for increasing profits in the forex market. However, its use requires the trader to have discipline, knowledge and risk management skills.