Even if you are not affiliated with the financial world or have never traded before, you still must have heard the terms “leverage” and “margin.” Forex and derivates trading domains are powered by this one primary concept – leverage – that makes them unique from all other investment products and trading styles. Considering the high significance of “leverage” in trading, it is essential to realize its intricacies and working procedures to minimize the overall risks.
In this write-up, we have discussed financial leverage in detail, exploring several questions like what is leverage in trading? How does it work? And how it can impact your trading endeavors. Let us look at them one by one.
Leverage meaning: What is Leverage in Trading?
Leverage refers to the “borrowing” of capital in order to magnify potential investment returns. It allows the traders to get augmented exposure to the financial markets with limited money.
In forex and CFD trading, leverage permits the traders to open much larger-sized trade orders relative to their account balance. Leveraged positions are maintained by the borrowed money from the broker, where traders target to achieve amplified gains.
For example, if you have a trading capital of $1,000, you can open orders worth up to $100,000 with a leverage ratio of 1:100. The maths here is that for every $1 of your deposit, you can place a trade valued up to $100.
Leverage in forex trading – How does it work?
Forex trading platforms usually allow some of the largest leverage ratios compared to other CFD assets. Forex traders can acquire exponential profits if the market moves in the same direction as speculated while they can exhaust all of their capital should the market move against their trade direction. However, the results greatly vary according to the applied leverage ratio and risk management measures.
Leverage and margin
Margin is the amount of money essential to open a leveraged trade. In other words, traders must put down a fraction of the total value of their position, known as margin, during leveraged trading. Margin is usually expressed in percentage – the lowest the margin percentage, the higher the corresponding leverage ratio.
To further understand how margin and leverage are used in forex trading, let us look at an example. Suppose your broker requires a 1% margin, and you desire to open a position worth $50,000 or a half standard lot of EUR/USD. In this case, you must have a capital of $500 – which is 1% of 50,000 units. The leverage ratio could be calculated by dividing the total value of the transaction by the required margin, which will be 100:1 (50,000/500) here. Similarly, if the margin requirement is 0.5%, the corresponding leverage will be 200:1.
Also, if you are still confused between leverage and margin, note that leverage indicates the multiplied-exposure ability of assets that can be materialized only if the traders hold the required amount of margin (deposit).
Positive aspects of using leverage
The positive side of leverage is that it offers the market players an opportunity to gain much more compared to their staked amount. Different from the traditional & slow investing procedures, leveraged trading lures traders who dream of multiplying their $100 to thousands of dollars in a limited period.
Leverage can indeed make these hopes a reality if the trades go correctly per the predicted direction. If a trader opens a 200:1 leveraged position on a capital of $1000, he gains an exposure worth $200,000. If all goes well, and $200,000 becomes $201,000, the trader will gain $1000 profit on his initial deposit of $1000. His account balance will get to $2000 with just one trade, a 100% growth rate not possible this swiftly with other investment products.
Risks of utilizing leverage in trading
While traders are enticed by a higher leverage ratio in hopes of gaining huge profits, they can also lose their capital if things go bad. Hence, the most famous tagline of leverage is that “it is a double-edged sword” that equally amplifies both your losses and profits. The risk increases in parallel with the real leverage applied to the opened trade positions.
Risk with 100:1 leverage
To better understand the risks, suppose you have $5000 in trading capital with a broker who allows 100:1 leverage, or in other words, requires a 1% margin. Next, you decide to place a “buy” trade on GBP/USD by utilizing this full leverage ratio of 100:1. It means you have opened a trade worth $500,000 ($5000 x 100) with only $5000 of your money. (Note that now your profits or losses will be calculated according to the “market exposed” amount, i.e., $500,000, and not your actual deposit. However, the deduction or additions will be on your real capital, making leverage a quite risky thing overall.)
That said, let’s assume the trade does not go according to your speculation, and GBP/USD falls down some pips where your $500,000 worth of trade is now valued at $497,000. Though it is just 0.6% down actually, you will bear a magnified loss of $3000 (calculated as per the leveraged amount) on your initial capital of $5000. Your account will be down 60% with just one trade due to excessive use of leverage. While the market moved just 0.6% down, you faced a 60% loss due to 100:1 leverage!
Risk with 10:1 leverage
On the other hand, if you apply a lower leverage ratio, suppose 10:1, your exposure in the market would be $50,000 (10 x $5000). Consequently, if the market moves 0.6% against you (similar to the above case), the loss here would be just $300, which is 0.6% of the $50,000 market exposed amount.
Hence, you will bear a loss of $300 on your initial capital of $5000. Your account will be down just 6% with 10:1 leverage compared to the 60% slump with 100:1 leverage.
The reality behind leveraged or margin trading
You might have come across small warning tags on brokers’ websites that 80% or 90% of retail traders end up losing money while trading CFDs. This is the reality of forex and CFD trading, as maintaining a long-term success rate in this domain is extremely tough. It would be correct to say that leveraged trading is a sort of sweet poison for most traders, who, while understanding the risks, repeatedly utilize excessive leverage ratios to become rich quickly.
Note that if you want to stand among the line of successful traders, you must understand that there are no shortcuts toward riches. You must be fully aware of leverage risks and try to place reasonable traders – slowly and steadily building your gains over time.
It is not impossible to benefit from leverage if you rely on the risk management tools like stop-loss orders to play safely amid risky leveraged conditions. Whether you want to become one of the 10% profitable traders by proceeding adroitly or plunge towards 90% of the failing traders is up to you.
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