Forex and the Concept of Leverage

By: Justin Stewart

Aside from the high amount of trading volume and potential profitability, the one single factor that has been enticing more traders into the Forex market versus the stock market is Leverage. Interestingly enough, many people enter the currency exchange market without a clue as to what leverage actually is. Hopefully, this content will give you some insight on what it is and how it works.

In the simplest of terms, leverage is defined two different ways:

Definition #1 - the use of borrowed capital or some other financial instrument, such as margin, in order to increase the potential return of a person's investment.

Definition #2 - the method of a business or corporation wherein they use an amount of their current debt to finance their assets. If a company's debt factor considerably exceeds their equity, they are labeled as being highly leveraged.

Relative to the first definition, when you're involved in currency trading (or stocks for that matter), leverage is normally created when you use various financial instruments, such as futures or options for example. Let's say that you have $1,000 in your Forex account to invest. You could do one of two things. You could waste that $1,000 on ten shares of Microsoft stock, or take that same $1,000 and invest it wisely in five different options contracts of 100 shares each. In so doing, that $1,000 of yours now controls 500 shares instead of only 10. To me the choice is obvious.

Now, relative to the second definition, most companies will use their debt to finance their assets and operations. When they do this, they create significant in that they can now invest in other business operations and their equity is undisturbed. For example, if a handful of investors take $5 million and invest it into the company that equates to a company equity factor of $5 million. This money is what finances company operations.

It follows then that if this particular company invests using the concept of debt financing, and if they use the concept to go out and borrow $20 million, then they now have a total of $25 million to invest in other business operations. This also benefits their shareholders due to the fact that values are also increased.

So let's apply the concept of leverage to the Forex market. In the Forex market, currency movements are monitored in what is called pips (a.k.a. points), which equates to the smallest movement that a currency makes. The pips are normally indicated by the 2nd or 4th decimal place within the price, depending on whether a two-decimal or a four-decimal place price is indicative of how a particular monetary unit is listed.

However, looking at this, you'll soon realize that these "movements" are relegated to mere fractions of a cent. To illustrate this, let's look at an arbitrary example of the British Pound (GBP) and the United States dollar (USD). If there is a movement of 100 pips in the GBP/USD price from 1.9500 to 1.9600, this means that the exchange rate moved only $0.01 (or 1 cent).

Foreign Exchange
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