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FAQ

How does leverage impact forex trading?

Off-exchange foreign currency trading carries a high level of risk and may not be suitable for all customers. The only funds that should ever be used to speculate in foreign currency trading, or any type of highly speculative investment, are funds that represent risk capital; in other words, funds you can afford to lose without affecting your financial situation.

Forex dealers can set their own minimum account sizes, so you will have to ask the dealer how much money you must put up to begin trading.

Most dealers will also require you to have a certain amount of money in your account for each transaction. This security deposit, sometimes called margin, is a percentage of the transaction value and may be different for different currencies.

Keep in mind that a security deposit acts as a performance bond and is not a down payment or partial payment for the transaction. Let s use an example of a dealer requiring a 1% security deposit. The formula for calculating the security deposit is:

The current price of the base currency X transaction size X security deposit % = security deposit requirement given in quote currency

Looking at the Euro example, multiply the current price of the base currency ($1.2178) times the transaction size of 100,000 times 1%. Your security deposit would be $1,217.80.

$1.2178 X 100,000 X .01 = $1,217.80

Security deposits allow customers to control transactions with a value many times larger than the funds in their accounts. In the previous example, $1,217.80 would control $121,780 worth of Euros.

This ability to control a large amount of one currency using a very small percentage of its value is called leverage. In our example, the leverage is 100:1 because the security deposit controls Euros worth 100 times the amount of the deposit.

Since leverage allows you to control large amounts of currency for a very small amount, it magnifies the percentage amount of your profits and losses. A profit or loss of $1,217.80 on the euro transaction is 1% of the full price but is 100% of the 1% security deposit.

The higher the leverage, the more likely you are to lose your entire investment if exchange rates go down when you expect them to go up or go up when you expect them to go down. Leverage of 100:1 means that you will lose your security deposit when the currency loses or gains 1% of its value, and you will lose more than your security deposit if the currency loses or gains more than 1% of its value. If you want to keep the position open, you may have to deposit additional funds to maintain a 1% security deposit.

For example, assume you buy or sell a contract worth $100,000 and it moves against you by $2,000. No matter how much money you put up, your dollar loss will always be the same "$2,000" but the percentage loss varies with the amount of leverage. At 100:4 leverage, you will have lost half of your investment. At 100:2 leverage, you will have lost your entire investment. And at 100:1 leverage, you will have lost twice your investment and owe the dealer $1,000.

You should check your Account Agreement with the dealer to see if the Agreement limits your losses. Some dealers guarantee that you will not lose more than you invest, which includes both the initial deposit and any subsequent deposits to keep the position open. Other dealers may charge you for losses that are greater than your investment.

(Source: NFA Forex Training )

You can find more tested trading systems at Colective2, TradingMatica, or Zulu Trade. Read disclosures found on relevant websites before using what they offer.

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