What is financial leverage?
Financial leverage is commonly used in trading. When it comes to the finance world, leverage means buying assets on credits. This act is carried out to avoid using up too much capital for one trade. The formula for leverage is the total debt owed divided by the trader’s equity. The higher the amount of debt, the higher the margin, if a trade, investment, or property is said to be highly geared, it only means that the amount of debt is treaty than the equity. An investor is said to be at an advantage when this type of debt is used in such a manner. Nevertheless, an unreasonable amount of margin can be risky, because if things don’t go according to plan, paying it back could become a problem.
Financial and operating margin differs from one another, operating margin consists of a business commodity that is measured as the total number of the fixed amount it will cost, if the fixed cost is high, the operating margin will also be high. In order words, leverage in business means the use of external funds for an investment, expansion, or acquisition of a property. Companies can as well use leveraged equity to acquire funds for their investors.
Why use financial leverage?
Margin trading is a popular activity in the world of traders, and it is used for these two common reasons:
- Expansion of an individual’s trade to obtain more proceeds on the risked capital.
- To generate more profits.
What is financial leverage in forex?
Financial leverage helps Forex traders to boost their accounts. With the help of this development, a trader will be able to place orders that are 1000 times greater than their capital. This is an avenue for traders to have access to higher volumes of trades than they initially anticipated.
How does financial leverage work?
For example, a trader has a total of $1,000 as capital in their trading account. 1 regular lot size is equal to 100,000 currency units. A trader with this volume of the deposit will be able to open trades without leverage, but they’ll be looking at a 2% profit, which is 20 USD.
This is the reason why most traders use financial leverage in trading, to boost the size of their trade and also increase potential profits. For instance, a trader with $1000 capital in their trading account but wants to trade larger volumes with a forex broker giving leverage of 1:500. This means that with the given leverage they will be able to trade 500 times their trade size, which equals to 500,000 USD maximum lots.
That means instead of making $1, they’ll be earning $500. On the other hand, in case of a bad investment you will suffer an increased (by the leverage) loss as well. It is advisable to use lower leverages if you’re not a professional trader, this will help you not to lose all your capital in case the market moves against you.
If you are applying a leverage of 1:100 while trading for example CFD and the asset price moves in your favor by 0,50%, that means that you are already earning 50% of your invested amount. The same can occur in case the price moves against you, losing 50% of your invested amount. There is a risk involved when trading and losses could occur as CFDs are complex instruments and come with a high risk of losing money rapidly because the leverage.
Which leverage to use in forex
It is difficult to choose the best level of leverage that should be used because it solely depends on the traders’ investment strategies. It is said that if you intend to keep a position open for a long time, you’re expected to use lesser leverage. It’s only reasonable because long positions are opened when there is an expectation of a large market stir.
Judging from this it can be seen that the margin ratio solely relies on the traders trading strategy being used. In order words, Scalpers and breakout traders utilize high leverages, because the trades are usually quick and snappy. While positional traders usually use low leverage or none.
The bottom line is to know when and how to use leverage in a trade. Hopefully, this article has helped you in understanding how leverage works, and how to calculate Forex leverage. It is also important to note the risk involved in margin trading, Forex trading is quite risky, and if not managed properly you could lose all your funds in a heart bit. Just as leverage can maximize your profits, it can as well maximize your losses. If you are not a professional trader yet, avoid using high leverage until you have fully grasped how the trade market works, and how to take advantage of the market.