In financial trading, leverage is a loan supplied by a broker, which facilitates a trader in being able to control a relatively large amount of money with a significantly lesser initial investment.
Leverage therefore allows traders to make a much greater return on investment compared to trading without any leverage.
Traders seek to make a profit from movements in financial markets, such as stocks and currencies.
Trading without any leverage would greatly diminish the potential rewards, so traders need to rely on leverage to make financial trading viable.
Generally, the higher the fluctuation of an instrument, the larger the potential leverage offered by brokers.
The market which offers the most leverage is undoubtedly the foreign exchange market, since currency fluctuations are relatively tiny.
Of course, traders can select their account leverage, which usually varies from 1:50 to 1:200 on most forex brokers, although many brokers now offer up to 1:500 leverage, meaning for every 1 unit of currency deposited by the trader, they can control up to 500 units of that same currency.
For example, if a trader was to deposit $1000 into a forex broker offering 500:1 leverage, it would mean the trader could control up to five hundred times their initial outlay, i.e. half a million dollars.
Likewise, if an investor using a 1:200 leveraged account, was trading with $2000, it means they would be actually controlling $400,000, i.e. borrowing an additional $398,000 from the broker.
Assuming this investment rises to $402,000 and the trader closes their trade, it means they would have achieved a 100% ROI by pocketing $2000.
With leverage, the potential for profit is clear to see. Likewise, it also gives rise to the possibility of losing a much greater amount of their capital, because, had the value of the asset turned against the trader, they could have lost their entire investment.
FX Regulators Clamp Down on Leverage Offered by Brokers
Back in multiple regulators including the United Kingdom’s Financial Conduct Authority (FCA) took material measures to protect retail clients trading rolling spot forex and contracts for difference (CFDs).
The measures followed after years of discussion and the result of a study which showed the vast majority of retail brokerage clients were losing money.
The regulations stipulated a leverage cap of 1:50 with newer clients being limited to 1:25 leverage.