Leverage refers to the usage of borrowed capital to carry out an investment. It involves the use of borrowed money to improve the rate of return on investment.
The usage of leverage exponentially multiplies the return on investment as it does the risk. Therefore, you must exercise caution when using it. Its use cuts across the financial and business sectors. This is because investors and companies seek to increase their investment returns by employing it.
Investors primarily use leverage for increasing their purchasing power. While companies use it to finance their assets instead of issuing stocks.
Leverage has become an integral part of forex trading. It allows people with low capital to make a substantial profit. This is because trading forex normally requires hefty capital in order to make any significant profit. Trading with leverage allows you to control larger amounts than you can normally afford. It is usually expressed in the form of ratios. The ratio is that of equity to the total funds used. Examples include, 1:10, 1:20, 1:50, 1:500.
Leverage vs Margin
Although these two terms are related, they are not one and the same. Leverage refers to the use of borrowed funds, while margin is the borrowed fund. For example, if a trader has equity of $1,000 and borrows $9,000 to take a $10,000 position. Then the leverage is 1:10, while the margin is $9,000.
How it works
In forex trading, it is the broker that offers leverage. Brokers usually have banks as partners that extend them credit. It is this they now extend to their clients. The amount offered by forex brokers differs from one another. In the forex market, leverage can be as high as 1:3,000.
Let’s say you have $10,000 in your forex account. The maximum volume you can trade is a micro lot (0.1 lots). If you take a position of this size and make a profit of $100 dollars, you would have made a 1% profit. Now if you were to engage leverage of 1:100, you would be able to trade 10 lots. Your $100 profit becomes $10,000, a whopping 100% profit.
However, caution must be exercised. In the example above, the use of leverage multiplied the profit. The same way it can multiply the loss. Therefore, a $100 loss would have meant the loss of the entire account.
Using leverage in trading has the following advantages:
- Reduction in equity requirement. You use less of your capital.
- Increase in potential returns.
- No interest. In forex, interest is not charged for using leverage.
The biggest disadvantage of using leverage is that it can greatly increase risk exposure. Lack of proper risk management can result in a painful loss of account. Therefore, caution is the best way to avoid a nail-biting loss.
In conclusion, making use of leverage is not a bad thing. It actually has its advantages. However, one must not be carried away and become reckless.
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