What is Leverage?
Leverage allows you to trade more units than you have. So if you have a mini account with a $1,000 (1,000 units) balance and you enter $100 (100 units) into a trade you can hold a $10,000 (a 10,000 unit) position. In this case, you would have 100:1 leverage. For every $1 you put into the market your broker puts in $99 to make it $100.
The important thing to remember about leverage is that it does not affect the value of a lot. You know that a mini-lot is 10,000 units of currency and a standard lot is 100,000 units. The value of these never changes no matter what your leverage is. If you have 400:1 leverage a mini-lot is still roughly $1 a pip. If you have 100:1 leverage that same mini-lot is still roughly $1 per pip.
Leverage does not affect the value of a lot but has an effect on the number of lots you can have in the market, based on the capital in your account.
The reason they call it leverage is because it is much like trying to lift a very heavy object. Some objects are just too heavy to lift. However, with the right leverage itís easy. If you have 100:1 leverage you can trade a mini lot (10,000 units) with just 100 units.
Leverage in Forex
Leverage may sound great, but it can cause problems too. The higher your leverage the more of your capital you can risk at one time, in comparison to a lower leverage.
If two traders have the same amount of capital, letís say $10,000 USD, and one has 100:1 leverage and the other has 400:1 leverage, the trader with 400:1 leverage will be able to risk more of his $10,000 at one time than the trader with 100:1 leverage. The trader with 400:1 leverage is required to have less in their account to cover their position.
Letís use some round numbers in order to better understand this concept. Again, take two traders with $10,000 USD in their accounts. Trader 1 takes a long position at 100:1 leverage on currency pair X/Y and buys 1 mini lot (10,000 units). Trader 2 takes the same long position at 400:1 leverage on currency pair X/Y and buys 1 mini lot (10,000 units).
Since Trader 1 has 100:1 leverage then he is required to have 100/1 or 1% of the position in his account. So for Trader 1 he will need to have at least $100 in his account which is 1% of 10,000 (1 mini lot). Since Trader 2 has 400:1 leverage then he is required to have 400/1 or 0.25% of the position in his account. For Trader 2 he will need to have at least $25 in his account which is 0.25% of 10,000 (1 mini lot).
Leverage be extremely dangerous. If you have $1,000 account with 400:1 leverage, for $100 you could trade four mini lots. If you take take a 100 pip loss on a trade, you could lose $400 on just one trade. You need to be very careful with leverage. In the end though, you are the one that determines the degree of your leverage. Your broker can only determine the maximum leverage allowed. If you choose to use the maximum that is up to you.