Trading with leverage: essential things to know
In financial markets, trading with leverage means trading partially with borrowed money.
The brokerage company that holds traders' accounts lends them additional funds so they can trade a much larger amount than they otherwise would be able to do. However, this comes with some enforced stop-loss levels so that each trader can't lose more than their account balance on all their open trades.
Why trade with leverage?
The potential rewards of trading with leverage can be significant because the trade size is much larger, so even a small price movement can lead to a large profit or loss.
So, for example, if you have an account balance of $1,000 but use a brokerage with a 20-1 leverage ratio, you could invest up to $20,000 in leveraged positions. If those positions make a 2 percent profit when closed out, the account balance will increase by $400, a 40% return on just a $1,000 investment. Then, on the next trade, up to $28,000 in leveraged positions would be possible ( $1,400 x 20).
But of course, the flip side is that any loss will be multiplied by the leverage ratio. Again, however, this risk should be controlled by the sensible placement of stop-loss orders relative to take-profit orders.
If, for example, a trader operates a trading plan whereby profit-taking orders are double the realized value of stop-loss orders, if the trader has a win-loss ratio of 50:50, then the overall return will be positive. This is because the trader will have used leverage to magnify the returns.
The broker will benefit from the increased fees and increased spread margins on larger trades than would otherwise have taken place. However, they may also charge interest on the leverage used if positions are carried over to the next trading day.
While traders are attracted to leveraged forex trading because of the potential riches, it's equally important to understand how that leverage can quickly lead to losses. Imagine the same scenario, except instead of a 2 percent profit, the trader suffers a 4 percent loss due to a sudden price swing. That 4 percent loss would cost $800. There would have been a far more significant total loss than if the trader had only lost 4 percent of their $1,000 principle, or $40.
What is margin?
Margin represents the minimum balance in your account required to continue trading open positions or taking new ones.
Leverage and margin are similar terms that every forex trader should understand. While leverage refers to the amount of loaned currency you can invest, margin refers to the minimum account balance that must be maintained.
Should an adverse price move occur, the broker may issue a margin call that requires the trader to deposit funds to cover the debt.
If the trader doesn't deposit more funds or the losses increase further, the broker automatically closes the trades to protect them from loss. This is known as forced liquidation of a trader's position.
How much leverage to use?
The trader's risk tolerance, the market's state, and the placement of profit take and stop loss orders should all be considered when determining the appropriate level of leverage.
Traders should first evaluate their level of risk tolerance to understand the maximum amount they can afford to lose without significantly impacting their financial situation.
Traders should then evaluate the state of the market. This entails examining the market's volatility, liquidity, and general trend. To protect themselves from potential losses, traders may use lower leverage levels when the market is highly volatile and unpredictable. On the other hand, traders may use higher leverage levels to increase their profits if the market is steady and predictable.
Finally, traders must consider placing stop loss and taking profit orders. These orders should use support and resistance. By placing these orders strategically, traders can limit potential losses and maximize profits. Traders can decide on the appropriate level of leverage to use once they have determined the proper placement of these orders.