The Concept of Leverage
Leveraging in the financial market has to do with using borrowed money to fund your investments. Most businesses use this concept mainly for growth, expansion, and asset acquisition purposes.
Leverage can also be described as having the capability to control large amounts of money with just a little of your own money whilst borrowing the rest.
Others define leverage as a strategy used in investment involving the use of borrowed capital to magnify the potential return on investment.
The concept of leverage is not uncommon in the forex market. Most forex traders borrow money from a broker to enable them to take larger positions in the currency, commodity, stock market, etc. Due to leverage, their returns are magnified when market conditions are favorable. The reverse is true when market conditions are unfavorable to them. It is therefore very necessary for forex traders to understand this concept of leverage thoroughly to manage their leverage and also employ the proper risk management strategies to avoid significant losses, which is not uncommon among uninformed traders.
Financial Leverage vs. Margin
Margin enables leveraging in that it involves using money as collateral to advance the buying power of an investor. Margin therefore allows an investor to borrow money from a broker for a fixed interest rate to buy currency pairs, stocks, commodities, etc. in anticipation of receiving a relatively high return.
In a nutshell, whilst leverage is the use of borrowed money to trade an asset, Margin is the collateral you deposit to enable you to obtain the loan. Leverage and margin are both twins in this regard.
Using margin to create leverage is very possible. You can increase your investment power by increasing the total amount in your margin account. This is how it works; if you require $10,000 as a down payment to purchase a worth of currency pairs, what this means is that you would have 10x leverage or a 1:10 margin. The investor now can control $100,000 with just $10,000.
What is a leverage ratio?
The leverage ratio is the level of debt incurred as against the total equity available. The leverage ratio shows how much the trade size is increased due to the margin required by the broker. If a trader buys $100,000 worth of GBP/JPY, they would be required to have a down payment of $1,000 in the account as a margin if the broker requires a 1% margin. The leverage ratio is expressed as $100,000 divided by $1,000 resulting in a leverage ratio of 100:1. This means that for every $1,000 deposit, an investor can purchase $100,000 of an asset. Notwithstanding, the leverage ratios are dependent on the market one is trading, the broker, and the size of your positions taken.
Maximum leverage and True Leverage
There is maximum leverage and there is true leverage, the two are not the same. When a broker advertises an offer of 500:1 or even 1000:1 leverage, what exactly are they communicating? What they are referring to is called the maximum leverage. This leverage ratio is dependent on the margin requirement of the broker. If the broker requires a margin of 0.1%, the leverage available is 1000:1; if it is 0.2%, the available leverage is 500: 1.
True leverage (effective leverage) is the full value or notional value of the positions you’ve taken divided by your margin (the total amount in your trading account). To understand the difference between maximum leverage and true leverage, look at the following calculations:
If an investor deposits $10,000 in their trading account and buys 1 standard lot 100,000 of GBP/JPY at a rate of $1.0000, the full value of the position taken is $100,000 and the account balance is $10,000. The true leverage is 10:1 ($100,000 / $10,000). If the investor buys another standard lot of GBP/JPY at the same price, the position taken is now $200,000 ($100,000×2), but the account balance remains $10,000 hence the true leverage is now 20:1 ($200,000 / $10,000).
If the investor goes ahead to purchase another standard lot of GBP/JPY at the same rate. The full amount of the positions taken is now $300,000 ($100,000×3) but the account balance remains $10,000. The true leverage is now 30:1 ($300,000 / $10,000).
If the broker requires a margin of 1% the account balance remains $10,000 in an ideal situation, but the Used Margin is $3,000 whilst the Usable Margin is $7,000.
Benefits and risks of using leverage
Benefits of Leverage
- Leveraging gives forex traders the ability to trade and participate effectively in the vast forex market, with a daily turnover exceeding $6 trillion.
- Leveraging significantly can magnify profit even from minute price movements, which is most attractive to day traders and scalpers.
- Leveraging can be used to manage risk since it affords traders the ability to open multiple positions. This risk management is applied when hedging against potential losses by taking positions in other trades.
- Leveraging enables traders to control larger positions while committing less of their own money to take advantage of the vast opportunities in the market.
Risks of Using Leverage
- Trading with high leverage can be emotionally traumatizing, especially when one is in a losing trade. The management of risks and the need to make rapid decisions can be very emotionally challenging.
- Leveraging can magnify losses and even help in blowing your account due to small adverse price movements.
- The danger of margin calls from brokers when the account balance falls below the broker’s margin requirement as a result of magnified losses. Once traders are unable to meet the margin call, they are at risk of having their positions closed in losses.
- The kind of leverage and position size engaged by traders can incur interest costs on the loan amount, eventually eating into the profit of investors.
Choosing the Right Leverage
The selection of the right leverage is dependent on several factors such as risk tolerance, level of experience in the market, etc. Investors should therefore choose leverage carefully.
Conservative traders or beginners should consider using lower leverage. Experienced or risk-tolerant traders may select higher leverage to maximize their profit. Seeing how improper management of leverage can magnify losses, it is better to make use of smaller amounts of leverage to avoid depleting trading accounts. Be reminded that leverage is flexible and customizable to each trader’s needs, hence be clever in your decision-making.
