What is leverage effect and lots?

Illustration: What is leverage effect and lots?

What is the leverage effect?

The leverage effect is the common term to describe a particular method used to increase profits. The most prevalent financial mechanisms using leverage effects are debt, long term asset purchases, and derivatives.

In the world of trading, the leverage effect allows traders to handle levels of positions higher than their account balance (this is called the margin).

So when an investor decides to open a position with more capital than he has available, he must use the leverage effect. For example, even with as little as 500 Euros, he can multiply his investment by 2, 5, 10, 50… even 400, with the leverage effect offered by his broker on his trading platform. This means profits made will also be increased, using a minimal investment.

The leverage effect is a key feature of Forex trading, as it is often quite high: up to 1,000 (x1,000) with some specialised brokers. It becomes thus possible to invest up to one thousand times more money than you actually have.

In practice, brokers are allowing their clients to trade with borrowed money so they do not have to invest tens of thousands of dollars in order to potentially make huge profits. When a trader uses a x100 leverage effect to make a transaction, this means that for every $1 the trader is investing on the market, the broker is investing $100. So you can be in charge of a $50,000 investment with only $500. Most brokers offer leverage effects of up to 1:400, at no cost.

In short, the higher the leverage effect, the greater the potential profit.

Leverage effect and risk

However, if you miscalculate, your losses will be equally increased as well. So it is a very risky mechanism with huge potential losses and traders should be very wary. The leverage effect can be a trader’s best strategy when used cautiously, or conversely your worst enemy if you are trading impulsively.

It is an excellent tool to increase profits and traders seldom make transactions without it, but you must keep in mind that the higher the leverage effect, the higher the risk as well.

What is a lot?

Every Forex transaction is carried out in lots, or currency rate contracts. A lot is the amount of capital invested after the leverage effect. It is also the minimum investment allowed by a broker. A standard lot is usually equal to 100,000 units of the base currency. It is the standardised unit used by brokers to quantify the volume of transactions on the Forex. Some brokers offer mini-lots (10,000 units of the currency) micro-lots (1,000 units), and more recently nano-lots (100 units).

Using lots makes it easier to work out the pip on a pair of currencies, and also helps to assess profit and loss faster.

Here is a specific example:

A trader expects the Euro to go up against the Dollar (EUR/USD pair) and buys Euros at a price of 1.3263. He buys a standard lot of 100,000. A pip will thus be 10 USD or (0.0001/1.3263)*100,000 = 7.5398 EUR. A few days later, the rate for EUR/USD has gone up and the trader decides to close his position at the exit price of the day (bid price of the EUR): 1.3288. His gross profit is 25 pips, or 250 USD, or 188.14 EUR. To work out his profit more accurately he must take the spread (broker fee) into account, usually 2 pips. So his profit is 23 pips, or 230 USD, or 173.09 EUR.