The use of leverage allows forex, or foreign exchange, traders to take positions on a large amount of currency with a small cash deposit. The use of leverage multiplies the profit or loss on forex trading in relation to the amount of money invested. Forex trading for individual investors could not function without the use of moderate to high levels of leverage.
Forex Trading
Forex trading is done in currency pairs. Traders make directional bets on the change in the relative value of two currencies, for example, the euro against the U.S. dollar. The exchange rate for this pair is quoted as "EUR/USD $1.3805." The quote is the cost of the first listed currency in the second currency. Traders place a buy order if they think the euro will rise in relation to the dollar and a sell order if the euro is expected to fall in relation to the dolalr. Note that currency trading is quoted out to four decimal places.
Forex Leverage
Forex brokers advertise and allow trading leverage at ratios of 50 to 1, 100 to 1 or even 400 to 1. The ratio defines how much of a margin amount a trader must have in his account to make a trade on a currency pair. The amount of money is based on the value of the trade size. For a trade of 100,000 of EUR/USD, the value of the trade is $138,050 at the price quoted above. At 100-to-1 leverage, the trader would make a margin deposit of $1,380.50, 1/100th of the trade value. At 50-to-1 leverage, the required margin amount would be twice as large.
Necessity of Leverage
The incremental value change of currency exchange rates is measured in increments of 1/100 of a cent, or $0.0001. In forex terminology, this increment is called a "pip." Currency exchange rates can change from a few to a few hundred pips per day. On $10,000 worth of currency, this is a few dollars to a few hundred. Traders are not willing to put up a $10,000 deposit on the change to gain or lose $20 or $50 during a one day trading period. With 100-to-1 leverage, the trader's deposit is $100. With this level of required deposit, the possible gains are attractive to the short-term trader.
Regulation of Leverage
A forex broker can be set up in one of several different countries and allow traders to make deposits and start trading. The regulations controlling a specific broker are dependent on the broker's home country. The amount of leverage a broker will allow depends on the local regulations. Forex leverage of 100 to 1 is widely available, and some brokers offer 200 to 1 and 400 to 1. In October 2010, the U.S. Commodity Futures Trading Commission limited the level of leverage offered by U.S.-based Forex brokers to 50 to 1.
Source - eHow
