Foreign capital may multiply your profit, but also your losses

Many articles were written about the way leverage works in finance and leverage trading. Yet this seemingly easy principle confuses many trade participants and its incorrect usage leads sometimes to very bad ending.

We have heard our readers and bring you most practical example, how leverage works, from a specific historical situation in the markets. We have chosen forex as an example.

Forex (also known as FX) is one of the most used words in the finance traders’ world. Forex is an abbreviation of “foreign exchange” and it means that foreign currencies are exchanged. Currency market is the biggest and most liquid market in the world, where currency pairs are traded internationally. Daily volumes of realized transactions surpass 5 trillion USD. The main currency pairs are EUR/USD, USD/JPY, GBP/USD and USD/CHF. Most traded currency is US dollar. Markets are open 24 hours a day, 5 days a week.

Forex trading essentially includes leverage products and financial derivatives usage, that enable the traders to multiply profits. Using contracts for difference (also known as CFD) with leverage effect leads to high profits even in the tiniest movements in currency pairs, and also to huge losses, if the exchange rate goes in the opposite direction than the trader expected. Learn more about CFD in this section.

Slight price changes and profits connected with them may be amplified by using financial leverage, when trader joins his own capital with foreign capital, that he borrows. When using leverage investments, it is quite common that foreign capital exceeds multiple time the amount of own capital.

For a better understanding of financial leverage trading we provide you a model case using a real movement of a currency pair. The currency pair in our case is EUR/USD. We will be watching movements on 9 January 2019, between 12.30pm and 8pm. The investor uses his own capital of 10,000 EUR. The table then shows you how the results differ when using different levels of financial leverage. The investor speculated that the currency will rise.

A model of how the leverage works when trading a currency pair (EUR / USD)

LeverageOpening priceClosing priceChange (%)Investment (EUR)Profit/loss (EUR)Spread* (EUR)
1:11,14381,15561,0310.000103,162,62
1:101,14381,15561,0310.0001031,6526,18
1:301,14381,15561,0310.0003094,9578,55
*Commissions: the table shows so-call “spread”, a broker’s commission, that is calculated from trader’s profit from the difference between buying and selling price. This is only a representative case, always make sure beforehand, what commissions your broker has and also other conditions for trading, before you sign a contract!

Let’s assume, that the investor opened his position on 9 January at 12.30pm, when EUR/USD value was 1,1438 and closed at the same day on 8pm, when the value was 1,1556. In this time frame EUR/USD value rose by 1.03%. The investor speculated in the right direction. EUR/USD is rising, which means that the investor received his profits. In other case, he would end the day with a loss.

Without using any financial leverage his profits would be 103 EUR. When using financial leverage, the profits become much more interesting. 1:10 leverage in this case offers a profit of 1,032 EUR and maximum allowed financial leverage for retail investors, which is 1:30, yields in 3,095 EUR. That means it is 30 times higher than in the case without leverage. On the other hand, all of this works in the same way for losses. If we changed the speculation direction of our client, that means speculating on a decrease, the trader would end in a loss and with maximum allowed financial leverage this would mean a loss of 3,095 EUR.

Due to risks in trading with CFD and other leverage products, the provider is by law not allowed to offer these products to everyone (the legislation may differ in various markets). The provider has to evaluate the client’s experience, wealth situation and preferences through investments questionnaire. Based on its result he may offer various products – from the non-risky to the riskiest. A solid investor with experience should not have problems getting authorized for CFD trading.

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