The foreign currency exchange (Forex) market is a large electronic network of banks, institutions and individual traders around the world who speculate on exchange rate fluctuation. The daily activity in the Forex market is more than 50 times the activity of the New York Stock Exchange. Many novice traders try Forex trading because it is open 24 hours per day, letting them trade while working other jobs. But the role of leverage in Forex trading substantially increases the risks.
Leverage
Leverage in any financial market lets traders take on much larger positions than normally available with their cash balance. This increases the potential for vast profits, but it also increases the risks. In the Forex market, leverage is necessary for most traders to earn a meaningful living, because exchange rates usually fluctuate in fractions of a penny. To profit from a move as small as one-hundredth of one percent, you must own large quantities of currency. Nearly all Forex brokers extend high leverage to their clients to facilitate the trading experience.
Leverage Ratio
The degree of leverage provided to Forex traders varies by country. In the United States, you can trade with 50:1 leverage, which means you multiply your cash balance by 50 to determine the buying power of your account. Thus, a $20,000 Forex account can trade $1 million worth of foreign currency. To determine the number of units of a currency you can purchase, multiply the amount of cash you plan to use on the trade by 50, then divide by the exchange rate. A $2,000 trade on a rate of 1.234 allows you to purchase just over 81,000 units of currency, worth approximately $100,000.
Risks
If you purchase $2,000 worth of currency at an exchange rate of 1.234, a move of one cent to 1.244, is multiplied by 81,000 units for a profit or loss of $810, depending on the direction of the trade. This is either a 40 percent profit or a 40 percent loss from just a single penny fluctuation in the exchange rate. This underscores the immense risks that leverage provides. Novice Forex traders who do not comprehend these risks usually lose nearly all their account balance in a short time, sometimes a few hours. You must trade particularly small positions if you are new to this market so the leverage doesn't put you out of business nearly as soon as you start.
Micro Accounts
While you do not often get the opportunity to request lower leverage in a brokerage account, you can open special Forex accounts that offer smaller position sizes. If you are new to the Forex market, you should consider "micro" accounts, which let you trade positions of only 1,000 units. The amount of cash necessary to open and trade in a micro account is usually less than $100, and it is a way to learn Forex trading without taking on excessive risks.
Source - eHow
