Why is leverage both beneficial and dangerous for traders?

Imagine that it is vital for you to make an expensive purchase, but the required amount is not at hand and is unlikely to appear in the next few years. Will it stop you? Not really, because you can use an ordinary loan and cope with the problem. A similar situation is observed in the foreign exchange market, where to start work you need to have a decent amount of money.

For traders who do not have such an amount, a special program has been created called margin trading. Its main idea is that the broker provides the bulk of the capital required to start trading. This service is called leverage.

It is due to the existence of such leverage that traders are able to trade with more money than they have available, and it is even possible to start trading if you have $10 on your account. Let’s consider in more detail what is the peculiarity of this tool and how to work with it correctly, as well as, benefits and dangers.

Leverage: Mechanics of Operation

In order not to describe the entire system in complex terms, we will analyze all the stages of a transaction using an example. Suppose a trader is ready to allocate only $1,000 for investing in Forex. Then the following happens:

  • On the account opened by the user, the broker reserves the missing amount ($99,000). Keep in mind that this money is not available for use; it only opens the door to the foreign exchange market. That is, the brokerage company does not risk anything.
  • The trading process is in progress. Here the profit/loss level is directly related to the lot size the user has chosen. Everything that he or she gains or loses is no longer tied to the size of the existing bet ($1,000), but to the margin account ($100,000).
  • In the case of winning, all the profit goes to the trader. The broker collects his reserve and standard commissions. In some cases, if the broker doesn’t have negative balance protection it could lead to traders owing money to the brokerage. A legitimate brokerage always provides negative balance protection and proper warnings about leverage as illustrated by this Axiory review specifically.
  • If the investor loses money, then upon reaching a critical point, the position is automatically closed. The allocated brokerage funds together with the commission, as in the previous situation, remain intact.

Which leverage should you choose?

As a general rule, decent brokers provide the trader with a choice of different leverage options. For example, 100:1. This means that the amount of capital pledged is 100 times the amount of funds available. By the way, this is the most common option, which is optimal for investors with small and medium deposits.

When trading, this proportion is explained as follows: if with a basic deposit of $1000, leverage of 100:1, the profit from the transaction is only 10 points, then the total profitability will be $100 (1 point = 1 dollar).

Without leverage, a similar result could be obtained if the investor had $100,000 in the account. If desired, a trader can independently change the size of the current leverage (options are available from 1:10 to 1: 500). To do this, just go to the personal account of the selected broker and make the appropriate rearrangement.

Leverage or a danger to the trader?

The previous example explained how the lending facility can help you generate tangible returns at the lowest cost. The problem is that everything has a downside. Therefore, if the trader’s forecast turns out to be incorrect, then he will incur losses incommensurate with the size of the investment.

If you take the same 10 points, with a deposit of $1000 and leverage of 100:1, then $100 will be equal to 10%. For one trade, this is an unacceptable loss (besides, with such a meagre protective order, the chances of failure are quite high). In most strategies, stop loss exceeds 50 points (50% of the available amount).

The situation can be corrected by using the basic rule for managing a trading account, which consists in not risking more than 1-3% in one position (for each trading system, these figures may differ). This means that when you deposit 1000, you need to reduce the leverage to 10:1 (or use an incomplete lot), so that one point becomes equal to $1 (or less). With this ratio, 10 points of loss will be equivalent to $10 or 1%.

Of course, the results may not be outrageous, but the risk of default is possible only with absolutely illiterate trading tactics.

The main advantage of leverage is the ability to make money in the foreign exchange market with a minimum amount of initial investment. At the same time, it should be noted that if the rules of money management are used incorrectly, such leverage can ruin a trader’s deposit in a matter of minutes. So it is always a good idea to find out more about this tool and use it properly.

Comments are closed.