'What you don't know can't hurt you'.
This widely used idiom may apply to some things in life, but certainly NOT when it comes to leverage! Quite literally, the MORE you know the BETTER!
What is leverage?
Leverage essentially means having the ability to control a large sum of capital using very little of your own funds and borrowing the rest. When you buy a house on credit i.e. a mortgage, for example, you are actually trading with leverage. Say you put a 25% down payment of $50,000 on a house worth $200,000, you are effectively using leverage here!
Leverage in the forex market is rather straightforward. For every $1 in your account you can control $X amount where X is greater than 1. For instance, 100:1 leverage means you control $100 for each $1 in your account. If you have $1,000 in your account this means that you can control $100,000 in positions.
The leverage achievable in the forex market, nonetheless, is immense in comparison to other markets. In the stock market, for example, the majority of leveraged accounts allows you to borrow at a 2:1 ratio i.e. a $10,000 deposit allows you to control $20,000. In forex, leverage of 500:1 is possible!
How does one use leverage?
This is always best explained using an example:
Terry the investor believes the EUR will strengthen against the US dollar in the coming months. He calculates his position size and wants to take a $100k position at (one standard lot) in the EUR/USD market at leverage of 100:1. Terry's current account balance stands at $10,000. The broker, assuming that the margin rate is 1%, would set aside $1,000 from the account (1% of 100,000 is 1000), thus leaving Terry with a usable free margin of $9000.
Why is there a margin rate and what the heck is free usable margin?
In a margin account, the broker uses the $1,000 as security. If Terry's position worsens or his losses exceed $9,000, the account will be trading at the margin level ($1,000). If this occurs, the broker will issue the dreaded margin call.
Free usable margin is the amount of account equity that is not currently being used to maintain the open position. Essentially, it is the amount available in the account to open additional positions, and the amount that the current position can move against Terry before receiving a margin call.
As you can see, margin is not a fee nor is it a transaction cost. If you buy on margin you're, in essence, borrowing money from your broker to trade. The deposit is considered margin which is required in order to use leverage.
Margin requirements differ from broker to broker. IC Markets offer very reasonable margin rates as low as 0.2% on most FX pairs, as well as flexible leverage options ranging from 1:1 to 1:500. With margin rates set at 0.2%, instead of $1000 margin being required as we saw in Terry's trade example above, the amount needed would have been $200 - quite a difference!
How much leverage should I use?
This is a common question and it really depends on the risk taken on a trade. Let's assume that you have a $5000 account and you risk 2% on each trade.
Let's also assume that you want to buy the EUR/USD at 1.1256, and have a stop set at 1.1246: a 10-pip stop loss. To trade this position, one would be required to enter using one standard lot, or $100,000. That's twenty times your account size you're trading there. However, by correctly sizing your position, you only have 2% of your account equity at risk even though you have a $100k position in the market.
Let's take this a step further and assume you wanted to risk 10% of your account on the same trade discussed above. This would equate to $500 of risk. To trade with a 10-pip stop, you'd then need to input five standard lots, or $500,000. Now, you're trading at leverage of 100:1 - 100 times your account size, but only risking 10%.
For beginner traders, we would strongly advise respecting leverage as it truly is a double-edged sword. Trade small to begin with and please RESPECT leverage!