The Leverage
When speaking about the principle of profit, we have mentioned the importance of the leverage in Forex trading, in particular, for private traders with relatively small capital. We have given an example of how the leverage works. By using the leverage, a relatively small amount of money on the forex trading accounts can be used for trading a sum 50-500 times higher.
Now let’s take a better look at how this mechanism really works.
For example, imagine that you have 100 US dollars in your forex trading account. In order to simplify the calculation, let’s assume that the leverage is 1:100. Let’s assume that you believe that the Japanese yen will grow in the near future and you decide to buy a maximum amount of this currency on the Forex. Since your deposit represents 100 dollars and the leverage is 1:100, you can operate with a sum of 10,000 dollars (100 dollars * 100 = 10,000 dollars). Your dealer, or more accurately the partner bank of your dealer, will issue you an interest-free target credit for the purchase of the said currency. Obviously, this money can only be spent on the Forex trading deal. To get such a credit, you have to fill out many forms, gather certificates, look for credit guarantors, and wait for a few weeks just like when you apply for a bank loan. This credit is issued “on the fly”, i.e. at the moment of making the deal. Thus, the bank adds 9,900 dollars to your 100 dollars, and, as a result, you have a sum 100 times greater.
With this sum you decide to buy some Japanese yen. Let’s say the rate is 1 to 120 (120 Japanese yen for 1 US dollar). Thus, you buy 120 * 10,000 = 1,200,000 Japanese yen. Assume, that your forecast about the growth of Japanese yen to the dollar does come true, and some time later (maybe, in a few minutes or in several months) the rate of the yen drops by 1 to 119. Do not worry by the figure going down from 120 to 119: the yen has really grown, because for 1 dollar you now have to pay fewer yen. We can also say that the “dollar has dropped to the Japanese yen” and the lower figure will make sense. Now you sell 1,200,000 Japanese yen and get 1,200,000: 119 = 10,084.03 dollars. After this, the bank takes away its9,900 dollars (don’t forget that the bank loaned them expecting a fast reimbursement of the debt) and you now have 10,084.03 - 9,900 = 184.03 dollars. Your forex trading profit is 84.03 dollars. Great!
Now let’s consider a less favorable situation, wherein your forecast turns sour and the yen rate drops to 121.21. In such a case, the situation is rather unpleasant: if you sell your 1,200,000 yen at the current rate you will make 1,200,000: 121.21 =9900.17 dollars. When the rate drops by an additional point and reaches 121.22, then, 1,200,000 yen will bring you only 1,200,000: 121.22 = 9899.36 dollars. This is less than the sum which you owe the bank, and it is evident that in such a situation, the dealer will have to forcefully close the deal at the current rate and return the bank its 9,900 dollars, and you will be left with only 17 cents. Such a situation is called “margin call”. In this situation the trader actually loses all his capital (in our example only 17 cents will be left from 100 dollars). To avoid such situations you need to learn to calculate possible losses in advance and close loss-making positions at the right time, using defensive stop orders.
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