Why is leverage a double-edged sword?

Leverage is a loan allocated by a broker to trade in the financial market. These borrowed funds may have different ratios and vary widely. So, there is a leverage of 1:4 and 1:500 and even more.

Today, most brokerage companies and dealing centers offer a financial leverage ratio of 1:100 - 1:500, but for large capitals, it is challenging to choose leverage above 1:20.

For a better understanding, consider the example of one brokerage company. Trading conditions assume financial leverage up to 1:1000. Thus, having $10 in the account, we can open transactions in volumes of up to $10,000.

In fact, leverage is the use of other people's money to buy or sell certain market assets. If the broker offers a 1:20 leverage, then this means that it is ready to allow the trader to borrow 20 times the amount of money on the trading account in order to conclude a deal. Thus, if the contract costs $ 10,000 and the broker offers a 1:20 leverage, then the trader will need only $ 500 in his account to buy this contract.

Leverage could be harmful and helpful at the same time, and this article will revolve around that topic.

How does it work in forex?

Forex industry has evolved in recent years, and a lot of people see it as a way to earn money. In order for you to become a good trader, you need profound knowledge and constant learning, let alone the real experience which you can gain in actual trading.

Leverage is very important in forex. It could bring you profits but at the same time disrupt you significantly. Imagine FX brokers that offer high leverage. First of all, it may seem attractive - a broker that has 1:500 leverage. It means that the total size of your trade if you open it at $100, will be 50,000$. Seems amazing right? Leverage is like a loan. If the trade is successful, a broker will take 49,500$. You will only have $500. Not a bad result if we look at it from a practical point of view.

But imagine another situation: you have lost the trade. You were unsuccessful, and you should return 49,500$ broker. Of course, you are unable to do that because you started at $100. In this situation, you should give a broker that money which you used to open the trade. Therefore you got into the situation which is more disadvantageous for you. You lost even more money and owed to the broker. Without the leverage, you would have lost only $1 or $2. What we are trying to demonstrate is that while leverage is indeed a good thing, in some cases, it could harm you significantly.

Risk control

In general, a trader should not use all available margins. By and large, a trader can use leverage only in cases where the chances are clearly leaning in his favour. For example, he must plan his trading and know exactly where to exit the transaction if the market moves in the opposite direction.

Once the risk value in points is known, you can determine how much money will be lost if a stop order is triggered. As a basic rule, you can establish that this loss never exceeds 3% of trading capital. If the position is increased due to leverage so that the potential loss is, say, 30% of the trading capital, then the leverage should be reduced until the potential loss returns to the level of 3%. Each trader has his risk parameters and may deviate from the base level of 3%.

Another thing that a trader should pay attention to is the more considerable the amount of money in the account, the easier it is to use leverage safely. Since using leverage you can lose money as fast as you can earn money, a trader should have enough capital to provide him with a “safety cushion” against any recession or adverse market movements, without the risk that positions will be automatically liquidated, leading to the loss of most of his trading capital.

The specific risk of leverage is that traders use borrowed money to trade in financial markets. If the market moves in the opposite direction to the open position, the losses will be increased by the amount of leverage used.

Conclusion

We think it is essential for every forex trader, especially for those who are just beginning to get accustomed to the basic principles and concepts of forex. Read available information on the Internet, seek pieces of advice from experienced traders about leverage. While there are arguments for and arguments against it, leverage is not an explicitly bad thing. You should know how to use it and how to deal with the outcome.