Traders in Forex trade a contract of currency exchange rates. As the movement of currency rates can be very small, traders use leverage to increase their profit potential.
Here is a step-by-step, practical example:
You decide to open a contract for trade and it has these elements in it:
The currency pair for trading – e.g. EUR/USD
The direction of the trade – BUY euro and SELL US dollars
The price – say 1.3500
The contract value – EUR 100,000
As the trader, you purchase this contract, believing you will profit once you close (offset) the contract.
If you are right (for example: the rate increased to 1.3600), then you would profit: for every euro in this contract you made profit of 1 US cent. In total, the profit would be $1,000 (100,000 x 1 cent).
However, do you need ALL the EUR 100,000 to open this contract?
The answer is: NO. You can LEVERAGE the trading: the trader is required to risk, for example, only 1:100 of the contract value. Accordingly, for a contract of 100,000 only $1,000 is needed. However, if there was loss, and the value of the WHOLE contact dropped to 99,000, then the deal is automatically closed, since the “guarantee” made by the trader was only $1,000.
With leverage, you have more money to use for trading than the balance in your account because you can ‘leverage” what you do have – that means you use what you have to increase the amount you can trade and to increase your profit when you succeed in trading in the right direction of a currency pair. On the other side, when there is a loss: the higher the leverage, the quicker you are subject to automatic closure of your deal.