In our last lesson we learned how to calculate profits in the forex market so we can determine our potential risk and reward in US Dollars before entering a trade. In today's lesson we are going to continue our forex trading course with a look at something which is known as leverage.
While the forex market has a reputation for being a very risky and volatile market, when talking about the main currency pairs of the world it is actually one of the least volatile markets there is. While a 2% move in a day is fairly common in many stocks and futures contracts, this would be considered a pretty large move in most of the main currency pairs and their crosses.
So if this is true then it begs the question of why the forex market has such reputation for being a very volatile and risky market to trade. The answer to this question has to do with something which is known as leverage and the fact that in the forex market traders are given access to a much higher amount of leverage than in most other markets.
When we talk about leverage in the financial markets we are talking about the ability to amplify the gain or loss on a trade through the use of either borrowed capital, or a financial instrument which is structured to accomplish this.
To point to an example that many people are familiar with lets look at what happens when most people go to buy a house. As most people do not have all the cash they need on hand to simply pay for the house out of pocket, they go to the bank and get a mortgage so that they can afford to buy the house. To obtain this loan the buyer of the home will generally put down some capital upfront, a common number for which is 20% of the purchase price.
So lets say for example that I go and take out a mortgage for a $1 Million house and put up 20% ($200,000) in order to obtain a mortgage from the bank for the balance of $800,000.
Next lets say that over the next year the value of my house goes up by 5% of the purchase price, so that the house which was worth $1 Million is now worth $1,050,000. While the value of my house in this example has gone up by 5% the return on the money that I invested in the house ($200,000) is actually much higher than this.
The reason for this is something which is known as leverage. As we can see from this example leverage allowed me to buy an asset (in this case a house) with only 1/5th the money that I would have needed had I put up all the money myself.
So in this example the return on my investment is not 5% but the increase in the value of the property ($50,000) divided by my down payment ($200,000). This equals a return of 5 times the 5% gain on the value of the property or 25%.
When people first see the power of leverage they normally get very excited, as the gambler seeking the slot machine jackpot that is in all of us starts to take over the brain. What it is important to realize however is that just as in this example a 5% gain in the value of the house resulted in a 25% gain on the original investment, if the value of the house falls by 5% in this example this would represent a loss of 25% on the original investment.
As we continue our discussion on leverage it will become clearer that one of the main reasons the forex market has a bad name, and why so many traders blow themselves up early on in the market, is because they over leverage themselves. While this may work to amplify their gains initially, eventually a loosing streak which always eventually comes does come along and knocks them out of the game completely.
For your homework assignment tonight I encourage you to place a few more trades on your demo trading accounts and notice how the different columns in the accounts window of the platform react when you do this. If you have not done so already you can register for a free real time demo account in the link above this video if you are watching on InformedTrades or to the right of this video if you are watching on YouTube.
Thats our lesson for today. In our next lesson we will look at the logistics of trading on margin on our real time demo trading accounts so we hope to see you in that lesson.
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Risk Disclosure: Trading forex on margin carries a high level of risk, and may not be suitable for all investors. The high degree of leverage can work against you as well as for you. Before deciding to invest in foreign exchange you should carefully consider your investment objectives, level of experience, and risk appetite. The possibility exists that you could sustain a loss of some or all of your initial investment and therefore you should not invest money that you cannot afford to lose. You should be aware of all the risks associated with foreign exchange trading, and seek advice from an independent financial advisor if you have any doubts.