PenWay.org

Forex

Leverage - The Forex Advantage

by Wayne Wargo (PenWay.org)

Leverage is the ratio of investment to actual value. Using an example of having $1,000 to buy a Forex contract with a $100,000 value is leveraging at a 1:100 ratio. The initial amount of $1,000 (margin), in this case, is what you have invested and all that you risk, but the possible gains are limitless.

Normally, the participants in this market are central and commercial banks, corporations, institutional investors, hedge funds, and private individuals.

In Forex markets, the goods are the currencies of the various countries. For example, you might want to buy euros with U.S. dollars, or vice-versa. The transactions are as basic as trading one currency for another. Of course, there is no actual physical inventory. You deal with any currency pair of your own choosing. You are strongly advised to never risk more than you can afford to lose. This should go without saying for any investment.

Forex trading is always done in currency pairs. For example, imagine that the exchange rate of EUR/USD (euros to US dollars) on a certain day is 1.1999 (this number is also referred to as a spot rate, or just rate, for short). If an investor had bought 1,000 euros on that date, he would have paid 1,199.00 U.S. dollars. If two weeks later, the Forex rate was 1.2222, the value of the euro has increased in relation to the U.S. dollar. The investor could now sell the 1,000 Euros in order to receive 1222.00 U.S. dollars. The investor would then have 23.00 more U.S. dollars than when he started.

The majority of currencies are traded against the U.S. dollar (USD), which is traded more than any other currency. The four currencies traded most frequently against the U.S. dollar are the euro (EUR), the Japanese yen (JPY), the British pound sterling (GBP) and the Swiss franc (CHF). These five currencies make up the majority of the market and are called the major currencies or the Majors. Some sources also include the Australian dollar (AUD) within the group of major currencies. One important thing to remember about Forex trading is the fact that one can trade using leverage, thus borrowing as much as 1,000 times your capital in order to make a trade. However, borrowing money for trading in foreign exchange is the same as borrowing it for other purposes—interest must be paid on the loan.

Currency trading involves both buying and selling, and the interest due on your loan can be offset by the interest earned on the currency you buy. In central banks, interest rates are set in accordance with a country’s monetary policy—high interest rates make the currency more expensive to buy and lower interest rates make it less so.

Because of rapidly rising prices in a country, the government may decide to raise interest rates. This would, of course, increase the overall cost of the country’s currency, and not only make the demand and consumption of the currency fall, as borrowing would become more expensive.

--- Related Articles ---