How does leverage work?

Question

Can someone give (or point me to) a concrete example of how leverage trading works?

Let's say in Forex. I have $1000, and I want to short/long the Euro at a 1:100 leverage. How much do I stand to gain? What exactly are my risks? Are there any risk to the company I'm trading via? Are the prices I trade in exact representations of the market, or am I trading in a "bubble market/simulation" of the real Forex market?

(That's a claim I've actually heard this week)

I found this question ... but I'm not looking for a "definition", rather for a concrete example.

Answer 1

JoeTaxpayer's answer adequately explained leverage and some of your risks.

Your risks also include:

1. If your balance drops too low, below the required margin, but still positive, the broker can close your trade. It has been reported that some forex brokers will review margin call accounts in an unscrupulous way, after reviewing the currency's chart for the day, closing out accounts at the worst price of the day instead of the price at which margin was insufficient.
2. Spikes. Some brokers report price spikes in the buying or selling price which can cause your trade to be closed out unfavorably. These spikes may or may not exist at other forex brokerages or in futures market prices.
3. Unlike the stock market and unlike the futures market, there is not a central forex market and so there is not a definitive price/time chart that could aid in holding a broker accountable for any unusual executions on your trades. You could indeed be trading in a small "bubble" of the "real" forex market.
4. Should your broker's internet site go down at the wrong time, or the broker have to close its doors, you may not be able to control your account for a time long enough to lose substantial amounts of money. Your account might then be closed for low margin, or closed out as zero or negative.
5. Unlike accounts for trading in the stock and futures markets, a forex account can not be easily transferred. This exacerbates risk (4), compared to what would happen at a bankrupt or government-seized stock or futures broker.

The firm's risk is that you will figure out a way to leave them with a negative account that contributes to another customer's profit and yet you disappear in a way that makes the negative account impossible to collect. Another risk is that you are not who you say you are, or that the money you invest is not yours. These are called "know your customer" risks.

Answer 2

For sake of simplicity, say the Euro is trading at $1.25. You have leveraged control of $100,000 given the 100x leverage. If you are bullish on the Euro, you are long 80,000 euros. For every 1% it rises, you gain $1000. If it drops by the same 1%, you are wiped out, you lost your $1000. With the contracts I am familiar with, there is a minimum margin, and your account is "marked to market" each night. If your positive balance drops too low, you get the margin call. It's a zero sum game, for every dollar you make, there's a guy on the other side of the trade. Odds are he's doing this full time and is smarter than you.