Understanding Leverage: The Good and the Bad

If If you’ve been following the news recently you might have heard that globally there is an economic recession underway due to COVID-19.

It is a concept that is discussed quite often for its merits and offered prospects, but rarely for the risks involved.

In this article we are aiming to provide the reader with a comprehensive view of leverage including all that’s good as well as all that’s bad.

Let’s start at the start.

Leverage defined

In trading, it is possible to borrow money from your broker to trade bigger positions.

This means that if you are trading a standard lot of USD, you don’t need to have 100,000 USD in your trading account. Taking 1:100 leverage would require you to actually use only 1000 USD from your account. The rest is leveraged.

The ratio 1:100 means that with 1 unit of a currency in your trading account, you can hold 100. The ratio goes up to 1:500. Different brokers have their own rules.

Remember that the leveraged amount actually is only in the numbers. Eventually your profit or loss is what is added to or taken from your account, the rest is just numbers on a screen.

 So, leverage is virtual credit. 

Essentially then leverage allows a trader to use external capital against their invested capital.

Why is it important?

There are two main reasons:

⦁ It allows people to trade in a market that would have otherwise been inaccessible.

⦁ It maximizes profits as the price fluctuation in a day is not too big.

Without leverage the average day trader could not have traded on a regular basis, and certainly not for the incentive of a 1% profit (which is what the average increase or decrease per day is for a currency).

The idea seems incredible and foolproof, but is it?

In short, no. It does come with strings attached. Let’s take a deeper look.

The Challenges

1. Bigger losses
It has been stated above that leverage allows traders to maximize their profits. However, this also means that losses too are maximized.

When your profit is being calculated against a standard lot, i.e. hundred thousand units of a currency (which you are trading through leverage), then should you incur a loss it would also be against a standard lot.

2. Little wiggle room

The other limitation this possibility for a big loss presents is that it restricts you further. Here’s how:

When a trader has a trade open that they are losing on, the broker will allow that loss to reach only a certain point. More than looking out for the trader’s interest, brokers are usually looking out for their own.

You see with leverage in play, it’s the broker’s money that is at risk. They only let a trader lose as much as their account can afford. This is so the broker doesn’t have to take the brunt of it and fair enough. Their job is to allow traders to participate but then their interest ends there.

Margin is the available capital in a trader’s account. This is that which a loss will be deducted from. If the broker sees that you are dangerously close to the limit of your margin, they will give you a margin call.

Margin call is your prompt to close your trades to avoid further loss, otherwise the broker will usually close your trades on their own.

The main problem here is that usually the market takes some time to form the trend you were hoping for. However, if you don’t have enough free capital in your account, there is a great chance that you will get margin called before anything can happen.

So for traders with small accounts, even when they take leverage, options still might be limited.

The Solution

There are, however, ways to limit the level to which you expose your account.

A few of these ways are given below:

⦁ Trade smaller lot sizes. This will allow you to open more trades at a time and also take a little more risk. Sure, the profit per trade might not be too much, but this is a great strategy for those who are just starting out. Besides, having one big trade ultimately gives you the same profit prospects that multiple smaller ones combined offer. If you are a day trader, smaller lot sizes and more frequent trades are best for you as you are participating in the market short term.

⦁ Test the volatility of a pair first. It is important to understand how pairs move in the market and what factors affect them. To develop this understanding a new trader should test those pairs either through observationor through small trades. Once you are confident about a trade then start implementing your final strategy.

⦁ Find a balance between taking and managing risk. Setting your stop loss too close to the entry means that you are not leaving any room for the market to do its thing. As discussed above, you will find yourself having to exit trades before the market has had a chance to give you a profit with the only difference being that it is your own stop loss making you close instead of a broker.

On the other hand, not using stop loss or setting it too far from entry can bring about avoidable losses. So, it is important to find the sweet middle.

In conclusion

Leverage is a very useful tool in forex trading and one that encourages many to join the market. However, like anything else in trading it is tricky to master.

As a trader you need to understand your options and also plan long term. This means that a trader shouldn’t be thinking about just today. If you’re looking to make trading a career, then prepare for it like you would in any other profession.

Figuring out the technicalities of leverage and risk management all fall under that preparation. Do your research on brokers and talk to other traders in your area to find out where you can get the best margin trading options.

With practice, you can master anything.

Good luck!