In finance, the term leverage refers to money which is borrowed by an investor (typically from a securities broker) in order to purchase larger amounts of securities than the investor’s capital would allow for.
The practice of leveraging, also known as gearing, allows investors to earn much larger profits than would otherwise be possible.
Example:
A forex trader invests purchases 10,000 U.S. dollars using their own capital. Eventually they close the position by selling their U.S. dollars at a profit of 0.5 centimes per dollar, for a total profit of 50 Swiss francs.
If they were to use a leverage ratio of 1:1000, the broker would lend them the money to buy 1000 dollars for every 1 dollar purchased their own capital. In this way, they could buy 10,010,000 U.S. dollars (assuming their margin is large enough to cover the loan). When they close their position at a profit of 0.5 centimes for every U.S. dollar sold, they would earn a profit of 50,050 Swiss francs – minus the interest charged on the loan by the broker.
Important: In the same way that leverage can multiply gains if rates perform in the investor’s favor, it can also multiply losses if rates do not perform as expected.
Using the example above, suppose the investor used a 1:1000 leverage ratio to purchase 10,010,000 U.S. dollars and the price of the U.S. dollar fell by the equivalent of 0.5 centimes per dollar. The investor could be forced to sell their U.S. dollars at a loss of 50,050 Swiss francs (plus interest charged on the loan) if they do not have a large enough margin to accommodate the loss until the rate increases.
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