The leverage in Forex as well as for the other markets on which you can negotiate is a peculiarity of online trading, which allows you to invest on a large number of lots on a considerably reduced budget.
In Lesson 5 We saw what are the lots, or the “packages” of shares or currencies on which to invest and which always have a “minimum lot”, or a minimum amount of shares or currencies that can be negotiated.
If the financial leverage was lacking, online trading would practically not exist. In fact, if you think of high-cost equities, it would be hard to find so many buyers ready to spend tens of thousands of euros to have a hundred shares. Instead, with online trading you can trade on Forex or other financial instruments with limited budgets but for high shares or currencies.
What is leverage?
Now let’s see what the leverage is. First, the term refers precisely to the effect of the lever in physical jargon, where it is used to indicate a mechanism that allows you to lift a high weight with an effort (force) less than that of the opposite weight. For example, you could raise 100 kg with a force of 5 kg.
Here, obviously we are not here to give lessons in physics, but in this way we can better explain the concept of leverage.
Bearing in mind this figure, imagine if in place of the kilograms there were the euro. With €5 we could move €100: In this case we would have a leverage of 1:20 (one to twenty). With a lever of 1:50 we could move €1,000 with €50.
How does the Forex lever work?
All this is very nice, but how is it possible? How come brokers give us the chance to earn money by investing in many more currencies than we could negotiate with our actual budget?
We answer these two questions from the last one. The leverage was always the first aspect on which “they did leverage” (excuse the joke) brokers in order to attract their customers. In order to offer this possibility, the broker must guarantee the solvency of the customer, a question that obliges us to answer the first question. How is that possible?
The leverage is like a small loan: The broker allows us to carry out large-scale and budget operations, but of course it must protect itself if the trader is unable to operate in the correct way and gets overwhelmed by unexpected results.
For example, if I want to do a madness and invest 100 euros in a company that loses because today I woke up so, the downside will start to make me lose and then the broker will receive signals like “This trader is losing a lot and is using the lever , it would be better to ask him a small amount covering any risks. ” This sum is called margin, which actually you pay even at the beginning.
This margin has the function of covering any wrong operations of the trader, since the broker through the lever finances the missing part of what is missing to the trader to operate with the prices of the actual lots.