Imagine if you had $10 that you wanted to spend at your local ice cream store. But then suppose you got a coupon for an extra $5 with every $10 purchase. You can’t redeem that $5 coupon for cash, but you can get $5 worth of extra ice cream with it. If that happened, you would have a total of $15 to spend (on ice cream) at the shop. That’s the general concept behind leverage.
When trading, leverage allows you to boost your trading potential. This is kind of like getting a ‘loan’ – you have X amount of capital and you receive Y extra amount from your bank to use, so your investment becomes X + Y.
Leverage is always communicated in terms of ratio. So for example, with 100:1 leverage, you can deposit $1,000 and open deals worth up to $100,000. It’s not that you now have $100,000 of course – but it means that you can open deals that are worth that sum. If they’re successful, you will enjoy a much greater profit potential, but – and that’s a big but – leverage also increases your risk.
Why greater risk?
Well, when you manage a deal that’s worth $100,000 with only $1,000 capital, you are more “sensitive” to volatility. It increases potential profits, but also potential losses. Of course, thanks to iFOREX’s Negative Balance Protection, your account can never go into minus. If you invest $1,000 and open deals on $100,000 using leverage, you can’t lose $100,000 – only $1,000, but high leverage does place you at risk running out of capital faster.
That said, leverage remains incredibly popular among online traders and no wonder. It’s a great tool in the right hands, but – like any other tool – you need to be careful and trained when using it.
Don’t confuse it with margin
What is the difference between margin and leverage? Margin is the amount you trade with in order to receive leverage. In our ice cream example, the margin would be the $10 you need in order to get the coupon. In an actual trade, an example would be the $1,000 you use, of your own capital, which will allow you to trade with $100,000. The $1,000 investment is the margin.
- Margin required is a percentage of money that is required by your broker to open a trading position
- Account margin represents the total sum of capital in your account
- Used Margin is how much money the broker has restricted in order for you to maintain an open position. Although the money belongs to you, you are not allowed to spend it until it is returned to you by your broker which often happens after you close a trading position. It can also be redeemed if you get a margin call
- Usable Margin is money available to you at your disposal. It is usually designated for trading only
- A Margin Call means that the amount of money in your account is unable to cover the potential loss. When this happens, the broker will close open positions at the market price.
In conclusion, just think of leverage as a powerful boost to your capital, one that allows you to open large deals with a relatively small investment. However: Remember that while leverage increases your profit potential, it also involves greater risk. Take your time getting to know this tool and train before you start using it.
What to learn more about leverage? Check out our What is Leverage page.