Leverage

Leverage: A short-term loan provided by a broker to increase the value of an investor’s investment. Leverage is described as the ratio between the principal and the broker’s investment.

Margin & Leverage

Margin & Leverage - text

So how do retail and part-time traders afford such large positions like 10,000 units of the EUR/USD, 28,000 units of the GBP/ JPY? The answer is leverage.
Trading with leverage allows traders to enter markets that would be otherwise restricted based on their account size. Leverage allows traders to open positions for more lots, more contracts, more shares etc. than they would otherwise be able to afford.

Let’s consider our broker the bank that will front us $100,000 to buy or sell a currency pair. To gain access to these funds they ask us to put down a good faith deposit of say $500 which they will hold but not necessarily keep. This is what we call our margin.

The margin requirement is always measured in the base currency i.e. the currency on the left of the FX pair.

Let’s look at an example. Say we are using a dollar platform and we wanted to buy a micro lot (1,000 units) of the EUR/GBP pair and our broker was offering us 200:1 leverage or 0.5% required margin.

Our broker will therefore take just €5 as margin and we were able to buy 1,000 units of the EUR/GBP pair. If we were using a US Dollar platform that €5 is automatically converted to dollars by our broker at the current exchange rate for the EUR/USD.