Few traders, especially beginners, understand the concept of leverage. Leverage is often encountered by novice traders who do not yet have their impressive capital but want to trade in the forex market or futures on the stock exchange.
What is leverage? What are the benefits of it? Is this tool always useful? What mistakes should you avoid when using leverage? We will tell you in our article.
Leverage – What’s All The Fuss About?
Leverage in Forex is borrowed funds provided by a brokerage company. Let us emphasize the word “borrowed” – this means that the broker does not give us real money, but only with the help of a special “lever” (hence the name) allows us to operate with a larger amount of funds than we could afford. This leverage guide can be of help if you need even more information.
Let’s say 1:100 leverage suggests that we can buy 100 times more units of stocks, currencies, or commodities. The ratio can be different: from 1:10 to 1:1000, and even more. For small deposits, considerable leverage is offered, whereas for large deposits – smaller ones.
We will give practical calculations of leveraged and unleveraged trading using the example of bonds for a better understanding. Let’s say we have 500 USD in our account, and we want to buy bonds at 100 USD apiece. In the absence of leverage, we could buy five bonds for all our money. It is easy to calculate: 500 (deposit) / 100 USD (price of one bond) = 5 (bonds).
As you can see, we simply would not have enough money for more. And with leverage of 1:100, we can buy 100 times more bonds, having all the same USD 500, i.e., 500 bonds. If, in our example, the quote went in the direction we need, and the price of the bond increased by 1 USD, then we would receive 1 USD profit from each bond.
Leverage: Examples To Come In Handy
Trading without leverage: 5 (bonds) x 1 (USD) = 5 USD (increment to the deposit). The total deposit on the account will be 500 + 5 = 505 USD.
Trading with a leverage of 1:100: 500 (bonds) x 1 (USD) = 500 USD (increment to the deposit). The total deposit on the account will be 500 + 500 = 1,000 USD.
As you can see, the advantage of using leverage is clear. But let’s look at the other side of the coin. Suppose we made a mistake with the forecast, and the price went against us; the cost of bonds fell by 1 USD and began to cost 99 USD per share. In this case, we would lose 1 USD from each bond.
When trading without leverage: 5 (bonds) x 1 (USD) = 5 USD (loss). Our deposit would have decreased by 5 USD and amounted to 500 – 5 = 495 USD. Trading with a 1:100 leverage: 500 (bonds) x 1 (USD) = 500 USD (loss). Our deposit would be: 500 – 500 = 0.
In other words, using the entire deposit in the transaction, with the established leverage of 1: 100, we would safely zero our account if the price fell by only 1 USD and would lose only a small part of it. Trading without leverage, but in a successful scenario, we could significantly increase the deposit.
A Win-Win Situation. Or Is It?
On the one hand, high leverage is an opportunity to make good money. On the other hand, you can quickly lose everything. What to do? There are two ways to reduce risks and increase potential trading profit simultaneously.
First, whichever leverage you choose, do not trade on the entire deposit. Ideally, each trade should account for 1-2% of the deposit.
Secondly, set stop loss levels, this will significantly reduce risks. Also, the amount of leverage is responsible for the total volume of open positions, since the margin is involved here (collateral funds in case of loss).
The higher the leverage, the lower the margin, and the more volume you can operate on. If trading with a 1:1 leverage, the margin (margin) is equal to 100 USD, then with a 1:100 leverage, it is 100 times less, i.e., 1 USD. Accordingly, with the leverage of 1:100, there will be more free funds on the account with which we can operate. With a more considerable margin (lower leverage), if the margin limit is exceeded, transactions will be automatically closed. You will not be able to trade with a large volume, which will also ensure your deposit.
To summarize: leverage gives the advantage of making deals in volumes tens, hundreds, or even thousands of times greater than our funds. With a skillful approach to leverage, the profit from trading increases, and the risk of a quick loss of the deposit decreases. The main thing is to trade wisely and not to forget about the pitfalls.