Leverage is oftentimes thrown around without actually understanding what’s behind it. If you’ve ever set foot in the financial markets, you have already experienced what leverage does to your trading performance. If it hasn’t been particularly good, worry not. Once you get how leverage works, your trading will skyrocket to better and bigger profits. This being said, understanding leverage is a stepping stone to every successful trading strategy. So, what exactly is leverage?
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Leverage is the use of borrowed funds, to put it in the most simplified version. More precisely, leverage in trading gives you more capital, considerably more, than your initial amount of funds. You can use this increased capital to trade in any market as you diversify your positions. Or you can choose to concentrate a larger amount of money on a single trade. It’s up to you.
By using leverage, you magnify your trading results. That means if a trade is profitable, you will get bigger profits. But if it’s a losing one, you could take a bigger hit. Let’s dive in and explore how this happens.
Forex markets, shortened from foreign exchange markets, are the place where all currency trading occurs. After the technological revolution in the early 2000s, electronic trading took over from the so-called trading pits.
Now, trading currencies is accessible by virtually anyone with an internet connection. Wall Street banks, corporations, hedge funds, and retail traders comprise this gigantic market with a daily turnover of $6.6 trillion.
In the forex markets, you can trade a wide range of currencies, all paired with one another. In other words, if you want to buy the euro, you need to sell another currency like the US dollar. That means you open a long position in the EUR/USD. You can also open a short position in which you sell the EUR/USD and expect to profit from its decline. Where is leverage in the dynamics of the forex market? Leverage is the firepower that gives you the opportunity to make a fortune in trading, especially if you choose higher leverage.
Leverage in forex allows you to open positions way bigger than the capital you invested, or the so-called margin required. With leverage, a trade where you control $10,000 could cost you as little as $20. The idea behind leverage is simple: it enables you to profit more from your trading activity.
In forex, especially, pairing your trades with leverage is the most common practice you can find. This is because retail traders do not usually invest millions of dollars. They could use a lever to bolster their positions with some more capital.
With this in mind, traders, both new and established, are greatly in favor of the idea of using borrowing capital to magnify their trading returns.
It should be noted, however, that leverage is a double-edged sword and works the same way in both directions. Therefore, if a trade goes against you, and you are using aggressive leverage, your account could get hurt. You can, however, mitigate losses if you have a proper trading strategy that involves healthy risk management.
To be a successful trader, you need a proper trading strategy. As a retail trader, no trading strategy is complete without the use of leverage. In other words, whatever way you design to trade and win in the markets, leverage will be involved.
With this in mind, it’s crucial for you to have a clear view of how you should approach leverage and make the most of it. On the one hand, leverage is designed to help you get more bang for your buck. Your return could be multiplied by as much as 500 times your initial capital. That’s the power of leverage.
But on the other hand, the same 500 times multiple could turn against you and cost you dearly. This is why when you create a trading strategy, you have to keep in mind that leverage amplifies both profits and losses. Choosing the right amount of leverage is a key risk assessment for you as a trader.
The way leverage works is, it is a process of automatically borrowing funds from your broker so you can reap bigger rewards from your trading positions. Depending on the amount of leverage you use, your broker will be giving you sizeable amounts of capital to invest. More specifically, leverage generally runs between 30:1 and 500:1. What does this mean? It describes the relationship between your broker’s capital and your own capital. This relationship is called the Leverage Ratio.
The leverage ratio applies to your funds relative to funds borrowed from your broker. It is also called the margin amount, or the capital required of you in order to open trades and successfully invest in any market. For example, a leverage of 100:1 means you need to put 1% of the chosen transaction size. The other 99% comes from your broker. In other words, for a trade worth $1,000, you would be required to invest only $10. Let’s put this into perspective.
If you open an account with $10,000, and you use the leverage of 100:1, you would have the buying power of $1,000,000. With this amount of money, you could buy everything and still have enough to cover some losses, right? Well, it’s not so simple. Technically, yes. But then again, you need to know that if leverage can magnify your wins, it does the same to your losses. Let’s give an example to make this clear.
Let’s say you have $10,000 in your account and you want to buy the USD/JPY. You believe the pair is currently undervalued and you expect an upside of 150 pips. Now you must decide the size of your position, or how much you want to own.
A decent amount of $500 of your own capital seems fitting. This is equal to 5% of your equity. This amount would give you control over $50,000 if you choose a leverage of 100:1. In that case, the value of a single pip would be $5. This said, your goal of 150 pips would yield $750. If you double your invested amount to $1,000, you would get back $1,500 if your prediction is correct.
On the other hand, if you are wrong, and invest $500 in your position, you would be losing the same amount: $5 per pip. Therefore, it’s important to pay attention and have proper risk management. When you go into the market, have a clear idea not only of how much you expect to gain, but also how much you are willing to lose.
Margin defines the amount with which you can open positions, while leverage decides by how much you increase those positions. This said, the margin is simply telling you how much money you need to enter the market, leverage boosts your capital. There is also the “margin call”, which is every investor’s biggest fear. A margin call is an alert from your broker that you have reached the minimum level in your account. During a margin call, all open positions will be automatically closed to prevent your account from a total wipeout.
Margin and leverage, however, work together. To give an example, a leverage of 100:1 would assume a margin of 1%. A leverage of 50:1 would assume a margin of 2%. A leverage of 200:1 would assume a margin of 0.5% and so on.
Trading with high leverage carries both elevated returns but also bigger risks that you need to control. Once you balance the relationship between these two, you will be safe to use as much leverage as you want, even up to 500:1.
If you are a risk-taker at heart, then higher leverage might be the way to go. Simply put, using higher leverage has the potential to skyrocket your returns like no other trading tool. Once you are certain that a position is about to unfold in your desired direction, higher leverage will fuel your capital. As a result, your total equity could see spectacular gains that will help you accelerate on your way to financial freedom.
In practice, higher leverage allows you to use a relatively small amount of money for substantial returns. You have to be mindful, however, that trading with higher leverage exposes your capital to higher risk unless you use a stop-loss order to protect it from any major drawdown.
Minimizing risk when trading with leverage could be done by keeping stop-loss orders with every position you open. A stop-loss, for that matter, is the level at which your position would be automatically closed if it turns against you. Stop losses help you minimize risk and keep it under control. Regardless of market events and price movements, a stop loss will give you peace of mind that your trading strategy will take care of itself.
Leveraged trading is the most common trading mechanism for retail investors. With it, you only need a fairly small amount of capital to control positions way bigger than your investment. By precisely calculating your leverage ratio, you would be able to expose your portfolio to multiple sectors at once.
You can go into any currency pair and buy it or sell it. Regardless of the forex pair of your choice, leverage could greatly enhance your trading performance as it boosts your returns. Trading with leverage brings you increased opportunities for magnified profits. It also carries certain risks, like magnified losses, in case your trades do not pan out. Still, leverage is used in every market. And by using leverage, you are increasing your chances of success in the market, moving closer to your trading goals.
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