LeverageWhat Is Financial Leverage?
The leverage in financial trading allows opening transactions with much greater value than the capital invested, hence a higher exposure compared to a relatively modest capital investment. A multiplier will be used in this case, for example it can be 1: 100, which means that the trade will work 100 times more than the amount used in the initial bid, generating profits and losses also multiplied by 100.
Thanks to the leverage effect, the amount you earn or lose may seem very high compared to the amount invested.
In practice, your broker will ask you to pay only a small part of the total value of your position and adding the rest of the capital required for the trade.
How does it work?
An average forex broker offers a leverage ratio of 1: 100 (or 1/100). Let’s make an example of a $10,000 minilot transaction: we only need to invest only $100 of our capital, i.e. 10,000 divided by 100 (your leverage), the rest will be on the broker.
As explained in the LOTS article, 1 minilot is $10,000 and each tick is worth $1.
So let's imagine we open a minilot in BUY of EUR/USD, at the current price of 1.1090 at a leverage of 1: 100. In this example, if the price rises from 1.1090 to 1.1098 we earned 8 pips, i.e. $8 (8% of our capital) on the other hand if the price falls by 8 pips we lose $8. With our $100 capital, before taking our balance to $0.00l, the price should drop by as much as 100 points. Again with margin call in place, the trader would have closed our trade at a probable 50% drawdown.
If your broker offers a leverage of 1: 200 you will need only $50 for the same $10,000 thereby risking a small figure over the actual value of the transaction.
If the price rises by 8 pips from 1.8090 to 1.0898, here we have earned $8 (16% of our capital!) as in the minilot, 1 pip is always worth $ 1 regardless of the lever. If the price falls by 8 ticks, we always lose $8. In this case, however, to lose all the capital, we need a reverse movement of 50 point.
In practice, by increasing your leverage you change the "speed" in which you can win or lose money: you increase the percentage gains (we risk only 50 and we potentially have double the percentage in gains) if used modestly.
For this reason, always choose a leverage that is not too low or too high. The more you are successful with trading with a low leverage, the less losing trades you will have, and the more you can experiment with a high leverage.
What are the benefits?
The main advantage is that, thanks to the leverage made available by the broker, an investment that would otherwise be too expensive is made possible for everyone. This puts traders in an advantage of not having to invest all the money needed to enter a position without the help of the broker.
By investing only a small part of the value of the assets you are interested in, allows us to make the most of our capital while retaining more liquidity in the portfolio that we can allocate to other investments by spreading capital more in a variety of assets rather than limiting yourself to one or two, by purchasing goods physically.
What are the disadvantages?
Leveragesamplify not only potential profits but also the losses, which can even exceed the initial investment in the event that the market moves sharply to your disadvantage. Some brokers automatically close a position when this has been completely compromised by the loss, but beware! Other brokers may continue to run the position even when there’s a negative signal, recovering this loss from the remaining balance of your account.
the Analyst's answerJean Grossett - Financial analyst
Though the use of leverage makes it possible for retail traders to be able to participate in trading CFDs, this tool should be applied with caution given that it is a “double edged sword”.
As traders we often have total control of trading choices we make which includes choice of broker, controlling how much we risk, strategy to deploy, and choice of leverage. With this much control and power, an uneducated newbie can easily go hell loose making irrational decisions taking on huge risks via choice of leverage.
The more leverage you take with respect to your investment capital can be likened to driving at 150miles/hour in a neighborhood that has speed limits set to 25miles/hour. Such a driver will definitely crash his car, hurt himself and others. Even if he is a Formula one driver he will not be able to do that consistently without eventually crashing his vehicle at some point.
Now remember in real life, the speed limits are set for you on the high way. At trading on the other hand your broker don’t set speed limits for you in the form of leverage. They only give you a range of leverages advertised as opportunities to take advantage of. So often times newbie traders are tempted to go for the higher leverage, without considering that when positions go against you, your capital gets exposed rapidly to margin call, and eventually closing of an account.
the Manager's answerRobert Danvil - Investment Manager
An advice … for newbie traders, venturing into trading for the first time. I will advise that they start with leverages as low as 1:30. This way you can get to understand if your strategy is working well and under what condition it performs poorly, giving your account space to breathe thereby earning the right to scale up in lot size as the account grows (compounds). Also carrying out rigorous analysis on data and subsequent back testing, demo trading your strategy, can give you insights into what leverage will be suitable for your trading strategy and choice of market.