Having hard-time understanding how Leverage works? Here are some illustrations of Leverage.
When most people think about investing, they think that they need large amounts of initial capital in order to start.
While this may be the case for stocks, bonds and other investments, Forex is much more accessible due to the use of leverage.
Example of Leverage in Real Estate
To explain, think of buying a home. You may want to buy a property that is worth $100,000, so you go to a bank to take out a loan or mortgage.
The bank request that you supplied 20% of the property as a down payment on your loan.
So for $20,000, you are now able to enter into ownership of a $100,000 home.
This is an illustration of leverage in Real Estate.
You have bought the home at a leverage of 5:1, since $20,000 is 1/5 of $100,000.
One year later, the property market has appreciated by 50% and you decide to sell the property for $150,000.
Making a $50,000 profit, if you would not taking out a bank loan and that used only your $20,000 to buy a small studio which cost that amount, your total profit after a 50% property price increase, would have been only $10,000.
Your 5:1 leverage has allowed you to earn five times more than you would have if you were traded without leverage.
Example of Leverage in Forex Trading
Let’s see how we can apply leverage to a Forex deal.
You currently have €1,000 to invest and you decided to buy €100,000 worth of EUR/USD at a rate of 1.3130 since 1000 is 100 of €100,000 using a leverage of 100:1.
The EUR/USD rate then moves up to 1.3140 and you decide to close your deal, making a 10 pip profit.
You can calculate that your total profit is $100, if you would not trading with leverage you would have only made a $1 profit.
In fact, depending on your account type and risk preference, you can trade much smaller or larger deal sizes, and use different levels of leverage.
It is important that you keep in mind that higher leverage can increase your potential profit but it can also lead to bigger potential losses.
Due to this risk, we encourage traders to plan their trades well by making sure they employ on risk management strategy and keep learning about the market.