How to Compare Forex Leverage to No Leverage

Leverage increases potential returns as well as potential losses.

Forex brokers typically offer huge leverage to clients. The amount of leverage offered may be 50:1, 100:1 or even 200:1. The leverage offered in Forex is greater than the leverage offered in other markets because currency values do not fluctuate as much as equity and commodity values. Leverage is a double-edged sword because it increases potential losses as well as potential returns.

Instructions

1. Determine the size of a Forex contract. A standard Forex contract represents 100,000 units of currency, although there are also mini lots of 10,000 units. A Forex contract is composed of a base currency and a quoted currency. For example, a standard EUR/USD or eurodollar contract represents 100,000 euros and the price represents the value of the euro in U.S. dollars.

2. Find out how much money you need in your account to buy the contract. This amount may vary by broker, but it is always much less than the amount of currency represented by a contract. For example, many brokers will allow someone to open an account with only a $1,000 or $2,000 margin.

3. Divide the full value of the contract by the amount of margin required to buy the contract. For example, if you are required to have $2,000 in margin in order to buy a standard contract worth $100,000, you're trading with 50:1 leverage. If you reduce the margin requirement to $1,000, you're trading with 100:1 leverage.

4. Compare the potential profits and losses offered by leverage to those that would be realized with no leverage. If the contract increases by $3,000 and you only have to put up $1,000 in margin to buy the contract (100:1 leverage), that means you've achieved a return on investment (ROI) of 200 percent. Compare this to trading with no leverage, or paying full value to trade a contract. Assuming the same $3,000 gain, your ROI in this situation would be a mere 3 percent. Of course, leverage works both ways, so potential losses are also greater when using leverage.

References

• How Does Leverage Work in the Forex Market?