Financial leverage in Forex (and in the other markets) is a peculiarity of online trading, which allows you to invest on a large number of lots with a greatly reduced budget.
In lesson 5 we saw what lots consist of. We also saw “packages” of shares or currencies that can be invested in with a required “minimum lot”, or a minimum amount of shares or currencies to be traded.
If there were no leverage, online trading would not exist. In fact, if you think of high-cost equities, it would be difficult to find many buyers ready to spend tens of thousands of euro to get a hundred shares. Because of leverage, you can trade Forex or other financial instruments on a limited budget but for a higher quantity of shares or currencies.
What is financial leverage?
Now let’s see what leverage consists of. First of all, the term refers to the effect of a lever, which is a simple machine that allows you to lift a heavier weight with a force lower than that of the opposite weight. For example, you could lift 100kg with a force of 5kg.
Of course we are not here to give you physics lessons, but in doing so we can better explain the concept of leverage.
With this figure in mind, imagine if they were euro instead of kilos. With €5 we could move €100: in this case we would have a leverage of 1:20 (one to twenty). With a lever of 1:100 we could move €10,000 with just €100, and so on.
Among those brokers that offer the highest leverage is 24option, a well-known, regulated, and authorized broker in Italy.
How does the Forex leverage work?
All of this is very interesting, but how is it possible? Why do brokers give us the opportunity to make money by investing in more currencies than we could trade with on our actual budget?
Let’s answer the second question first. Leverage has always been the first aspect with which brokers try to attract customers. In order to offer this, however, the broker must guarantee the creditworthiness of the client, a question which obliges us to answer the first question. How is this possible?
Leverage is like a small loan: the broker allows us to carry out operations on a large scale and budget but he obviously must protect himself in case the trader is not able to operate in the right way and become overwhelmed by unexpected results.
To avoid bad surprises, the broker provides the trader with a very important tool: stop loss. With stop loss, the trader can set a maximum loss level, which if eventually reached, closes the loss position automatically.
For example, if I woke up today and decided I wanted to splurge and invest 100 euro in a losing company, its downturn would lose me my money and the broker would receive signals such as “this trader is losing a lot and is using leverage, we need to ask for a small amount to cover our risks”. This sum is called margin, which is also paid at the beginning of a transaction.
This margin covers any risky transactions made by the trader because the broker, through leverage, finances the missing amount for the trader in order for the latter to operate with actual prices of lots.
Please refer you to the lessons on margin and leverage for more information. You can start practicing by opening a free demo account with Plus500.
Go to the next lesson – Forex Leverage in Practice