FOREX Leveraging
The term "leveraging"
refers to buying a contract with a small down payment. You do
this when you buy a house or car when you don't have the full
cash amount. A car might cost $30,000, but you only have $500.
You pay the $500 as a down payment, and you sign a promissory
note (loan agreement), either with the owner of the car or with
a financing company, to pay the remainder over a period of time.
Of course, the longer you take to pay, the more interest you
pay. But the fact remains that you got a $30,000 car for $500
cash. That's leveraging. You have paid a small amount of money
to make a big purchase.
In the FOREX market, you typically buy a contract for 1% of its value. You might, for example, purchase $100,000 in US dollars by paying $1,000 now. If you keep that money, you must pay for it over time and you will pay interest. But typically, you resell that contract at some future date, when you expect that the US dollar will be worth more than it is today, and hopefully for more than the cost of the contract plus any interest and brokerage charges.
The way leveraging benefits you is this:
Suppose you buy 10 bricks for $10. You pay cash. You put the bricks in your garage and never use them. After a year, you decide that it's silly to have these bricks lying around, so you decide to sell them. You ask your neighbour, and he says he wants them, so he decides to buy them from you. You haggle over the price. Currently, bricks sell for $1.50 each. Your neighbour wants a discount, and since you paid only $10, you decide to sell them to him for $1.25 each, or $12.50 in total. He's happy because he didn't have to pay $15 to buy 10 bricks, which is the current price. You're happy because you made a $2.50 profit on your $10 purchase. That's better than a kick in the head. You made a 25% profit on your money. Your $10 turned into $12.50 after a year.
Can't beat that.
Or can you?
Suppose you decided to sell bricks for a living. You suspect there will be a shortage of bricks in a year or two, so you use your $10 as a down payment on a loan for $100, which you use to buy 100 bricks.
A year goes by. You have not made any payments on the loan, and the interest has amounted to $8 after a year.
Bricks are now selling for $1.50 each.
You sell all your bricks, gaining $150. You now pay off the loan and the interest, which is $108. So you are $42 ahead. Your $10 turned into $42 after a year.
That's leveraging.
