Say for instance that you are investing in real estates by buying a property that worth $100,000. However, you do not have enough cash.
So, you went to a bank to take a mortgage loan. The bank request that you supply 20% of property value as down payment of your loan.
So for $20,000, you are now able to enter into an ownership of a $100,000 property. This is an illustration of leverage in real estate. You have bought the property with the leverage which the bank bank has provided at 1:5, since $20,000 is one-fifth (1/5) of $100,000.
One year later, the property market appreciated by 50%. You decided to sell your property at the price of $150,000, making a $50,000 profit.
If you would have not taken the bank loan, and use only your $20,000 to buy a smaller property that worth $20,000, your total profit after a 50% property price increase would have been only been $10,000.
The 1:5 leverage provided by the bank has allow you to earn 5 times more than you would have if you have entered into the investment without leverage.
Now, let’s see how leverage is applied in forex trading.
You currently have 2,000 USD cash as capital (initial deposit) to invest in forex trading.
A broker has provided you a leverage of 1:50. With the leverage, you will have access to 100,000 USD capital, which is 50 times of your intial deposit. With 100,000 USD, you will be able to enter into a position of 1.00 standard lot.
You decided to enter into a position of buying 1.00 lot EURUSD at 1.08600.
The EURUSD rate then moves up to 1.08700 and you decided to close your deal, making a 10 pips profit.
Using the profit and loss formula, you can calculate that your total profit is 100 USD.
Should you have not traded with leverage, you will only be able to utilize your own $2,000 cash, enter into a position of 0.02 lot and make a 2.00 USD profit with the same 10 pips price movement.
The 1:50 leverage provided by the broker has allow you to earn 50 times more than you would have if you have entered into the position without leverage.
Risk Warning: Leverage can increase your potential profit, but it can also lead to greater potential losses.