To put it simply, leverage is trading with borrowed money. Most foreign exchange brokers offer traders far greater leverage than brokers in the equities and futures market, which is what makes forex more appealing to certain types of traders. With that said, it is crucial to note that leverage is a double-edged sword: it can significantly increase traders earnings, but it can significantly increase their losses as well, if not used properly.

Leverage and Margin

Brokers that offer traders leverage will also stipulate margin requirements, which is the amount of money the trader must have in their account. For instance, brokers that offer a maximum of 20:1 leverage are stating that for every 20 units of currency the trader purchases, he/she must have 1 unit in their account. Many forex brokers offer as much as 100:1 leverage; some even go as high as 400:1 leverage.

Margin Calls

Because traders using leverage are trading with borrowed money, there is the possibility that they could lose more money than they have in their account. To avoid this situation, most forex brokers employ what is known as an automated margin call. Automated margin calls occur when the value of the trader's account falls below the margin requirement; when this happens, most forex brokers will simply go ahead and automatically close the trader out of their position, so that they do not end up with a negative account balance.

To better understand how this works, consider the following example:

A trader purchases 100,000 EURUSD. The broker the trader is working with has a margin requirement of $1,000 per 100,000 units traded. Suppose the trader has $5,000 in their account.

In such a scenario, each pip is worth $10. If the EURUSD goes 401 pips against the trader, the trader will have a floating loss of -4,010 US dollars (401 pips * 10 dollars per pip). Since the trader had an initial balance of $5,000, the floating value of their account will be $990 (the initial balance of $5,000 - the floating loss of $4,010 = $990). This is below the margin requirement the broker has stipulated. As a result, the broker has the right to close the position automatically -- without the trader's consent.

Leverage Enables Greater Control of Risk

Though leverage is generally thought of as risky, it can in fact be a tool that traders can use to achieve greater precision of the risk they are exposed to. For instance, many traders use leverage trading assets that are relatively non-volatile. This allows leverage, which can be precisely controlled, to be the primary source of risk -- as opposed to the asset's volatility, which cannot be controlled by the trader at all. This line of thought is common amongst forex traders, as currencies tend to move in a very narrow range relative to stocks and futures; a 2% move in price in a single day is extraordinary for a currency, but is considered the norm in many equities markets. As a result, forex traders who use leverage to trade non-volatile currencies enjoy greater control and precision of the risk they are exposed to, as they are relying on the leverage ratio they choose more so than the underlying asset's volatility.

In sum, traders should use leverage cautiously: it can enhance earnings significantly and is widely used amongst active forex traders -- but it remains the primary reason forex traders, particularly those new to the market, blow up their account.

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