Aug 24 2020 10:42AM
What is Leverage?
If you are like many people when starting their forex journey, leverage is among the mysteries that take a while to grasp.
The concept of borrowing money to do business, make a profit and afterwards, return the borrowed capital and keep the profit is what leverage is about. Let’s dive in.
Say you want to buy a phone costing $1000 so you can resell at $1100 to make a profit. At the time, you only have $900 so you will be glad to get a lender to borrow you 100$ to achieve your trade.
Let’s say you go to Mr Ayawo, he borrows you 100$ at no interest, now you have 1000$. The contribution is in ratio 9:1(leverage).
Now you do the trade make $100 profit and return Mr Ayawo’s 100$ contribution.
You have just achieved the trade using a 1:9 leverage from Mr Ayawo. If the phone had cost 500, you would have provided $450 while mr.ayawo provides 50$ to maintain a 1:9 leverage.
If you had only $800 and needed 200$ extra, the leverage would be 4:1 meaning you will provide 80% of your trade requirement (usually called required margin percentage).
Proceeding with example 1.1, Let’s say because of economic change, after buying the phone for 1000$, the selling price(controlled by market activity) drops to 950$. If you sell at this price,
You have made a loss of 50$, you must return the borrowers 200$ and now you are left with 750$.
This makes sense because even in regular trades, borrowed funds must be returned regardless of whether business ends in profit or not for the trader.
Can I lose money gotten with leverage?
Since in forex, prices and market activities are perpetual, your trade will only keep running so far you are in profit. Once your trade starts losing, you are only allowed to loose up to your own contributed margin for the trade. In this case 800$ looking at example 1.1, once you lose close to 800$, there is a Margin Call on the trade.
Which just means you need to fund in more from you balance to continue the trade or the trade is closed automatically.
Must I use Leverage?
Now imagine if you had contributed 100% of the required margin($1000), then your trade can not be affected by margin call and you can lose the total contributed margin(your money).
Also, Imagine you only contributed 1% of the required margin ($10, that is using 99:1 leverage), the worst that can happen is losing only 10$ and if profit happened, you would still keep it all.
Is it advisable to use high leverage(Advantages & Disadvantages of leverage)?
Ideally, you should be using all the leverage available whenever possible.
But I do see some people advice not to use high Leverage Why?
if you are using high leverage(you contribute little of the margin required), when loss starts, you will have enough time directly proportionate to your margin to still be in the market because margin call will happen once loss gets close to your margin which is actually a shorter time than if you used low leverage.
So high leverage allows fewer losses while low leverage allows more losses.
Let’s say the phone selling price go from p1 1000$ to p2 850$ to p3 1100$(final price).
The trade in example 1.0 would lose because it would be closed by margin call while the trade in example 1.1 can tolerate losses until price fall reaches 800$. So this trade will continue and turn in profit when the price gets to 1100$.
Will I pay interest on leverage?
Absolutely not, any broker charging interest on leverage should be left alone. Some brokers charge hidden fees though but you should deal with a transparent broker e.g Octa FX
Learn more in the Forex 202 course will even fund your account depending on the offer you choose.