If you're one of the millions of people baffled by the financial news, you've probably heard of a term called 'leverage'. When used in forex programs, leverage is a very useful tool, and we're going to explain some key concepts about both forex and leverage in the next few paragraphs.
Right now, leverage is something of a 'dirty word', because investment banks made a hash out of overleveraging their positions during the housing bubble. A lot of forex traders do the same thing, but it's still a useful tool.
Here's how it works: You want to buy an option on several hundred thousand units of a currency, which you expect to be able to sell at a profit in a short period of time (hours to days on the outside). The problem is that you don't have the money to buy all that currency yourself.
So you talk to your broker, who lends you the money to buy the currency. The currency goes up, you sell it, pay back the broker with interest, and have a significantly larger profit.
Foe example, if everything works out right, you can take $1,000 of your own money, use it as collateral for a $19,000 loan, make 4% on the swing on the $20,000 currency trade you executed, turning $20,000 into, pay your broker about $200 for the use of their $19,000, and walk way with a $600 profit on your original $1,000 investment in the course of a few hours.
This is a fairly idealized transaction, and a lot of brokers try to pool small investors together to get more favorable rates on making leveraged bids. They can also be made 'in reverse' when you're playing a short position.
The problem with leverage is that it magnifies the risk. If you guess wrong, you may end up losing more money on a leveraged transaction than if you'd not taken the loan out entirely. While it's a valuable tool, it's the financial services equivalent of playing with a chainsaw.
This is the very basics on using leverage to swing bigger trades as a forex trader. There's a lot more to it, but with this, you should be able to understand a lot of what you're seeing down the road.
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