When trading, leverage is a tool used to increase the size of a position. It is available across various trades but is particularly useful when trading forex. Below, we discuss how to understand and use leverage when trading.
Have you ever seen a stock or share, and wanted to invest more than you have available? Leverage is a tool that allows you to do this, by borrowing money from a broker. However, the potential increase in profit also means it can result in significant losses. To fully understand how to use leverage, read our expert guide below.
What Is Leverage?
Leverage is a trading strategy that uses borrowed money for investment. This allows investors of stocks, shares, and securities to trade using larger positions. It is a widespread technique often used by those who
trade forex
. You may also hear it referred to as margin trading.
Leverage does come with some caveats. Using borrowed capital can greatly increase gains, but it can also enhance losses. Therefore, leverage needs to be used and understood carefully before you decide to use it for trading purposes.
How Does Leverage In Trading Work?
When using leverage, you are borrowing money to put toward the asset. For example, imagine a trader was going to buy shares in Tesla to the value of $10,000. If they have a maximum leverage value of 4:1, then they could buy x4 the amount, meaning their shares would be worth $40,000.
Leverage Ratios
Different types of trade will have access to different ratios of leverage. Some of the most important ones are below.
Forex trading
When trading in currency,
forex leverage
is available in some of the highest ratios. This means there is a large chance of making a profit, but also of a loss.
Indices
Indices are trades in a
group of related assets
. They have ratios just slightly under that of forex and are typically at around 20:1.
Stocks
Stock trading has a lower ratio than indices and forex. It is typically around 5:1. When bigger trades are opened, this will decrease and the margin will go up.
What Is The Margin In Leverage?
The margin is important to know when using leverage, as they work in conjunction. It is a way for the lender, in this case, the person providing the leverage, to cover the risk to credit in the case of a loss. Imagine it as a deposit for a loan. It is the difference between the loan amount and the total value of the investment.
Generally, money
deposited in an account
can be used for trading. Imagine you have a leverage value of 5:1. For every $1 in your account, you can get $5 of trades. The 1 becomes the collateral and thus means margin is the amount needed to open a trade, while leverage is the amount you can borrow to increase the position.
Leverage In Forex Trading
One of the areas where leverage is most valuable is when trading forex. Here, leverage ratios are extremely high in comparison to futures and equities. The reason for this is that currency prices usually trade by less than 1% in a day. That allows brokers to offer leverage as high as 100:1, as the risk is much lower.
Another reason is that forex trades must be carried out in large amounts. Forex is measured in pips, which are the fourth decimal place of a transaction. In reality, this is a very small amount, usually a fractional amount of a cent or penny for example. Therefore, these tiny movements only bring value if they are purchased in large quantities. If you buy $100 worth of currency and it moves slightly, you earn or lose very little. When you do it with $10 million worth, more profit or loss is available.
Downsides To Forex Leverage
The risk with any leverage, in forex or other trades, is that it can also mean significant losses as well as gains. As you are borrowing money, then the broker needs a way to safeguard themselves against losses and that is payable by you, the investor.
When it comes to deciding how much leverage should be used, it depends on your level of risk. Some investors will be willing to go for full amounts, while others will be more restrained. If you are just learning how to trade in forex, then lower levels are advisable. This can be increased once you understand the forex market a little more and how leverage works.
Leverage is a tool for trading, and like any investment carries a risk. You should always only invest what you can afford to lose. When using leverage factor the margin into this. It is easy to get carried away as it can seem like free money. With careful planning, you should be able to use leverage in forex and other trades to your advantage.
