Leverage is simply borrowed funds that traders use to trade. In other words, it refers to the ability that traders have when opening an account with a forex broker, to borrow funds in order to trade with a bigger amount than what they have initially deposited in their trading account. In this way, they gain a larger exposure when trading in the financial markets, with a relatively small initial deposit.
Leverage in trading is a double-edged sword. It enables traders to potentially magnify their profits if the market moves in their favour, but losses as well, if the market moves against them. This happens because both profits and losses are based on the full value of the position rather that the deposit amount only.
Leverage & margin
Margin is the amount needed to open a position. In other words, it is the amount needed to open a trade with leverage. Trading forex on margin means that you are only required to pay a portion of the total value of the position, which will be considered a deposit. Margin rates usually start at 3.3% for the most commonly traded currency pairs such as EUR/USD or GBP/USD, but this differs between CFD brokers.
It is a well-known fact, that the foreign exchange market offers low margin rates, hence high leverage ratios, compared to other assets. In fact, if we compare forex and stocks, the leverage difference is much higher.
Leverage in the stock markets starts from 5:1. This makes forex quite attractive for traders who are into trading with leverage. In fact, a 3.3% margin rate for example, means 30:1 leverage which in turn means that for every dollar in a trading account, traders can trade up to 30 dollars.
How does leveraged trading work?
As already mentioned, leverage is when using debt to trade and results in potentially multiplying one’s returns or losses. Both traders and companies use leverage. The former use it to potentially boost their profits while the latter use it to fund their assets in the attempt to boost shareholder value.
Leverage works by using margin to give you a much greater exposure regarding a specific asset, as already mentioned. What you are actually doing, is providing a percentage of the total value of your trade and then the broker is lending you the rest. The exposure you gain is also known as leverage ratio.
For example, let’s say you have 10 thousand dollars in your trading account, and you want to invest in a company that is trading at $50 per share. If you buy shares with just the cash you own, you could afford 200 shares whereas if you use margin and borrow $10,000 from a forex broker, you could afford 400 instead. If the share had a 10% increase, you would earn a 20% profit if you had invested with cash while with margin, you would earn a 40% profit. Nevertheless, if the share decreased in value and dropped to $40, you would lose $2,000 with cash and $4,000 with margin. Keep in mind that you always need to pay the broker back for the borrowed money.
Benefits of using leverage
One of the main advantages of trading with leverage is that traders get to increase potential profits by only putting down a percentage of the total value of the trade so as to receive the same profit as in a normal trade. Remember to always consider the full value of the trade and the possible downsides.
Moreover, trading with leverage can make capital committed to other investments available. The ability to increase the available investment amount is also known as “gearing”.
Additionally, the ability to trade with leveraged products to speculate on how the market moves gives traders the ability to take advantage of both falling and rising markets, which is also known as going short. Finally, leveraged trading is available around the clock. Although there are various trading hours that differ from market to market, some other markets like forex, indices and cryptocurrencies are available 24/7.
Risks of using leverage
To start with, trading can increase losses as well. It is very likely that traders will forget the amount of funds they are risking because the initial amount is relatively smaller compared to conventional trades. So, as already mentioned, you should always consider the full value of the trade as well as possible disadvantages so as to develop risk management steps.
Furthermore, trading with leverage means that you are not in a position to actually own the asset, so you have no shareholder privileges.
What is more, in the case that the market moves against you, the broker you are working with may require that you add more capital to keep the trade open. This is commonly known as “margin call”. There are actually two options here. You will either exit the trade or add money to lessen the exposure. Since when using leverage, you are basically borrowing money to open the full position but at the deposit cost, there can also be small fees that can be charged to cover the costs in case that you want to keep your position open overnight.
How to manage risk
As discussed throughout the whole article, leverage involves the risk of losses exceeding your expectations. However, there are various risk-management techniques that can be used to limit potential losses. A stop-loss order aims at limiting losses in a market that is not so favourable, by making you exit a trade that moves against you based on the predetermined price. What happens with stop-loss orders is that you basically determine the amount you can afford to risk. Nevertheless, keep in mind that since markets move too fast, there might be specific conditions that may not trigger your stop-loss order at the set price.
For the reasons outlined above, new traders should maybe start with leverage once they feel familiar using it and first practise using a demo account.