Meaning Of Leverage And Its Importance For ForeTraders

August 29, 2022
Forex Trading

If financial markets are your only source of income, leverage is a necessary term you must be aware of. Many forex beginners are confused about leverage and end up blowing their whole trading account. In simple words, leverage refers to a type of credit which is offered by brokers to forex traders so that they can open large positions which can turn out to be profitable for them. On a macro level, leverage is widely used by many countries and companies worldwide. Let’s understand the term by way of an example: Say an entrepreneur starts a business with $5 million and goes to a bank to take an additional loan of $30 million to purchase stock and machinery. Thus, the entrepreneur is bound to pay the bank a part of his revenue. If he is unable to do so, the bank can force him to liquidate.

How is Leverage Used in Forex Trading?

The concept explained above is applicable to the forex market as well. Various forex brokerage firms want their clients to earn huge profits, so they offer them different leverage levels. This helps traders and investors to trade more financial instruments and take advantage of all the opportunities available in the market. The one thing the traders must bear in mind is leverage ratios are always represented in the ratios such as 5:1, 500:1 and many more.

Leverage Ratio

The leverage size offered by the brokers depends upon the assets being traded. For Example: when it comes to cryptocurrencies, their maximum amount of leverage is quite low compared to currencies such as EUR/USD. This is so because cryptocurrencies are more volatile in nature. In addition, the leverage for certain assets can also be minimized if one expects a market-moving event. This is basically done to minimize the impact of major shocks on the market. In previous years, there have been various such events that led to the brokers reducing the amount of funds being borrowed by the traders, such as the 2016 elections in the USA and the Brexit vote.

The amount that the brokers allow to lend traders help them to trade more; they even help them with those assets they could not have without leverage. For Example: if a trader has $1,000 in his trading account, it is tough for him to trade gold futures if, let’s assume, they are traded at $1,200. However, if the trader uses the leverage ratio of 100:1, he is able to buy gold futures worth $100,000.

Types of Markets Where You Can Trade Using Leverage

Leverage trading allows you to trade in multiple assets such as currencies, stocks, indices, cryptos, commodities and more. All you need is to find a broker that can offer leverage so that you can take advantage of it.

How to Compute Leverage Ratio?

There is a simple formula to compute leverage as below:

L= A/E

Where L= leverage

A= amount of the asset

E= margin account

Significance of Leverage in Trading

Firstly, leverage minimizes the capital amount which a trader requires to open a trading position. Many people earlier thought of trading mainly as a venture which is meant for big investors with lots of money. However, with leverage, small traders even with $100 capital can get to experience forex trading. All they need to do is find a reasonable leverage ratio, and you would be able to deal in funds which would be much more than your initial capital.

Furthermore, trading is also a valuable tool to maximize your gains. Whenever a financial instrument’s price rises, the traders can get a substantial profit based on the ratio used. It’s worth mentioning that the size of leverage used by traders greatly impacts the trading account.

Bottom Line

For forex traders, the significance of leverage cannot be underestimated. Therefore, they should take some time out and evaluate their risk-bearing capacity before deciding the money size they want to borrow from the brokers.

Experienced professionals with impeccable knowledge about risk management can utilize high leverage ratios so as to maximize their profits. On the other hand, for forex beginners who are just starting out, it is recommended they must use a low leverage ratio. Although the profits will be less, the trader would feel more comfortable knowing they are not exposed to greater risks.

Author lerin