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Sunday, November 14, 2010

Leverage?

Ok, time to discuss about leverage in Forex.

When I first started delving into the Forex world I used to wonder "How do people make money trading currencies? The movements are so negligible!"

Let's say for example that the pair EUR/USD is trading at 1.4000. That means you would spend $1.4000 dollars for every Euro you wanted to buy. You would enter this trade wanting the Euro to go up. Let's say you have $1400 US Dollars and you buy 1000 Euros with them. Now you have 1000 Euros and hope the Euro goes up against the dollar.

One day later the pair EUR/USD is trading at 1.4010 (up +0.0010, that is a tenth of a cent). Now if you wanted to sell your 1000 EUR they would be worth 1000 x 1.4010 = 1401 US dollars. And you would be winning 1 US dollars on the trade. Do you get the picture? trade 1400 US dollars only to gain one?

In order to make this trading worth while, Leverage comes into the equation. Leverage will allow you to control more units of money than what you are actually putting on the line. If your broker offers a 100:1 leverage, that means you can control 100 units of currency per every real unit you trade.

Following the example above. You have 1400 USD that allow you to buy 1000 EUR. Since your broker provides you with a 100:1 leverage, you are in fact controlling 1000 x 100 = 100 000 EUR. Now one day later EUR/USD = 1.4010 and instead of winning only $1 you are winning $100, due to the 100 to one leverage.

Now, leverage is a double edge sword. It increases the speed at which you can make profits, but at the same time it increases the speed at which you have losses. That is the first thing. Second, you enter trades losing more money by default right from the beginning. When you enter the position you usually enter near the ASK price, and sell near the BID. The ASK is what sellers are willing to receive in order to sell you the position, whereas the BID is what buyers are expecting in order to buy your position (that is when you want to sell). The difference between BID ans ASK is known as spread. When you enter a position (at the ASK) and immediately want to sell it (at the BID), you are losing the spread. In the example of the article let's say the EUR/USD was listed at BID=1.3997 ASK=1.4000. You enter buy buying at the ASK, but if you want to sell that position you will be doing it at 1.3997. That loss of 3 pips would represent $30 in our example. Imagine how big it could be with a higher leverage!!

So, the lesson is this one: Leverage can make your trading worth while, however leverage is not your Best Friend Forever. Leverage doesn't care about you and it can be your enemy as well. And last but not least: Be afraid of Brokers touting their "400:1 incredible leverage!!".

If you want to learn all the ins and outs of leverage visit these interesting, practical and funny articles at babypips.


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