April 15th 2021 News

What is Leverage? – A Beginner’s Guide

Back to blog
Leverage


You will encounter the term “leverage” almost every time you decide to conduct trading in any market, whether it be forex or stocks or cryptocurrencies. However, it is a surprising fact that the majority of novice traders who enter the market have misconceptions or have incomplete ideas about the concept. Leverage, which is considered a double-edged sword can do more harm than good if not properly implemented while trading.

What is leverage? (Leverage Definition)

Leverage can be explained as a tool that increases the purchasing power of your deposit. It is funded either by the broker or liquidity provider working with the broker. Higher the leverage, the more funds you can invest in trading.

Leverage trading is primarily used in Forex as very small price movements can produce quick and easy profits.

When trading FX, the leverage traders can access is typically higher than in other markets. For example, equity markets usually provide you with a leverage of 2:1. Compare this with the 15:1 standard leverage in Futures markets. Now, the Forex market dwarfs both of these markets as the leverage tends to be upwards of 50:1.

When you see leverage when trading with a broker, you will usually see it in the form of leverage ratios. The leverage offered is usually 50:1, 100:1, 200:1 and so on. For instance, if you decide to trade with a leverage of 200:1, it means that you can place a trade of $200 for every $1 in your trading account. When selecting leverage ratios to trade with, always be sensible. It’s not always necessary to trade on the highest ratios available to you. You can choose a more conservative path by depositing more money, making fewer trades and using a lower leverage ratio.

How do you calculate leverage?

To calculate leverage, you need to establish 2 important parameters first:

  • The amount of money you are willing to risk on a single trade
  • The distance between your entry order and stop loss.

Here, if you have an account of $10,000 and you are willing to risk 2% of your account, the allowable risk per trade will be 2%*$10,000=$200.

Now if the leverage is changed to 1:100, the trader only has to give $100 to trade $10000. Another trader who does not use any leverage will have to deposit the entire $10,000 to trade the same amount.

What is Margin?(Relationship between leverage and margin)

Margin is an amount temporarily held by your broker until your trade order is closed or settled. The margin is credited back to your balance once the position is liquidated and the order is closed. Margin is expressed in percentage and depends on what leverage your broker offers. For example, a Leverage of 1:100 requires a margin of 1% and leverage of 1:50 requires a margin of 2%.

What’s the best financial leverage ratio for a beginner to use?

The majority of novice traders are attracted to leverage-based earning strategies which can help them earn more money in a relatively short period of time. But always remember at the back of your mind that leverage is associated with certain risks. To grasp this concept, you need to understand certain concepts directly related to money management in leveraged trading.

When trading in FX, always try to maintain low levels of leverage. You can use trailing stops to reduce downside and protect capital. Limiting the capital to 1 or 2% on each position taken is a good practice.

As a novice, you should choose the level of leverage that makes you most comfortable. A lower leverage level of 5:1 or 10:1 is appropriate for individuals who are conservative and don’t like taking many risks or for those who are novices. By using limit stops or trailing stops, you can learn how to trade in FX and limit potential losses if the trade fails.

Why High Leverage Is Risky?

In the past, many brokers offered significantly higher leverage ratios compared to today. Leverage of 400:1 allowed you to control $1000,000 worth of currency in the FX market using just a $250 deposit. However, financial regulations have limited the ratio brokers can offer to many countries in the world.

So let us take the example of a trader who has $16000 in his/her account. If he chooses to use a leverage of 50:1, he can control up to $800,000 (50*16,000). In FX trading, this means 8 standard lots (8*100,000). This is one of the basic trade sizes in the FX market, with the other two being a mini lot and a micro lot. These represent 10,000 and 1,000 units of the quote currency respectively. The term “pip” is used to describe the movements in currency prices. where one pip in a standard lot represents a 10 unit change. A one pip movement in a standard lot means that it will change by 10 units.

Since the trader in our example, purchases 8 standard lots, each pip is valued at $10/100,000*800,000= $80. In this case, if the trade goes against the trader by 80 pips, the trader will lose $6400 (80 pips*$80). This amounts to 40% of the total $10,000. The risk is obvious in this case.

Why Use Leverage?

  • By using leverage you can earn income from assets and currencies that you would normally not be able to afford.
  • Even though your broker provides you with the funds for trading with leverage, it doesn’t incur any interest.
  • You can increase the scope of your profit if you utilize leverage in your trading.

Cons of leverage

  • Using a high leverage can be dangerous if the market suddenly moves against you. You should thus always be attentive and never forget to move away when suffering a losing streak.
  • There is always a risk that you will fall under the margin requirements stated by the broker. In such cases, the broker may instigate a margin call which will automatically liquidate your portfolio.

Final Thoughts

Professional investors and casual traders use higher levels of leverage to trade more efficiently. With leverage, you can drastically increase your purchasing power and potentially increase in more stocks or currencies, depending on whichever market they are in. However, the “double-edged sword” characteristic of leverage should always be considered. Too much leverage can mean too much risk for a trader to take in.