In investment term, when you leverage, you are essentially borrowing on margin to increase the size of your trade beyond what funds you have on hand.

In stocks and other equities, you can create leverage trading on your account, which may allow you to as much as double your purchase.

However, in Forex, doubling the purchase is simply unheard of in most cases. Depending on your broker's terms, in Forex world, you may be able to control 50, 100 or even 200 times your account balance.

Therefore, leverage simply means using a small sum to control a much larger sum. This is possible because it is unlikely that the value of a currency will change by more than a certain percentage over a short time. So you can place a few hundred dollars in your brokerage account to trade on the margin - the amount that you think the price will fall. Your broker will in effect lend you the balance.

This can lead to big profits if you are successful, but it can also mean big losses if not. In general, the more leverage you use, the more risky your trading is.

We could understand leverage and margins more by looking at the following example:

Imagine that the current rate on the British pound to US dollar is shown as GBP/USD 1.7100. So to buy one British pound you would need $1.71. If you expect the value of the dollar to rise against the pound you might decide to sell enough pounds to buy $100,000. If your broker uses lots of $10,000 each, these would be 10 lots. Then you would sit back and wait for the price to go up.

A few days later you might find that the price had moved to GBP/USD 1.6600. Sure enough, the dollar has risen and the pound is now worth only $1.66. If you sell your dollars now and buy back into pounds, you will have made a profit of 2.9% less the spread. 2.9% of $100,000 is $2,900, so that would be an excellent trade.

But most of us do not have $100,000 spare cash that we want to trade on the currency exchange market. So here is where the principle of Forex margins comes into play.

Since you are buying and selling different currencies at the same time, your own money only has to cover any loss that you might make if the dollar falls instead of rising. And you would put a stop loss into place to limit that loss, so $1,000 might be all you needed to have in your account to make this $100,000 purchase. Your broker guarantees the other $99,000.

In fact many brokers now operate limited risk amounts where the account will automatically close out the trade if whatever funds you have in your account are lost. This prevents margin calls, which can be disastrous for a trader because they mean that you can lose more than you have. But with a Forex limited risk account that is not a possibility. The broker's software that you use to control your account will not let you lose more than your account balance.

Using leverage in this way is so common in currency trading that you will soon do it without even thinking about it. Still it is important to keep in mind the risks. Lower leverage is always safer and you may never want to go to the maximum Forex margin that your broker would allow.

Being able to leverage is one of the biggest reasons why people are trading in Forex, but it’s also one of the biggest reasons why people lose money. Be careful to manage your leverage position when trading, especially when starting out.