Why and how leverage can help you increase your trading profits
Leverage in the financial markets refers to borrowed capital from your broker that can be used to open positions with just a margin of the initial position size. Depending on the jurisdiction, the broker’s offering and your account type – you may be offered different levels of leverage or margin requirements according to the asset classes you will be trading.
Since leverage increases the number of units of currency or stocks you can trade, if the market moves against your position, you may be liable to pay for the losses as well as the leverage amount provided by your broker.
How leverage works in the forex market
In the trading conditions offered by your broker, you will usually see the maximum leverage ratio available. For forex this can range from 50:1 to 1000:1 though these are extreme amounts and should be avoided by beginner traders. Keep in mind that financial regulators that provide oversight to the financial trading industry have been trying to restrict the amount of leverage brokers provide to customers due to the risks involved.
A 50:1 leverage ratio means that for every $1 you are trading, your broker can provide you with up to $50 in borrowed capital, therefore you only need 2% margin in order to cover a trade. Note that the amount of leverage you are applying on every trade can be customized according to your risk appetite and tolerance.
If you have $1.000 dollars in your trading account and your broker offers 50:1 leverage, then a 5% gain in the asset you are trading could mean $2.500 in profit. Whereas without leverage, you would be making only $50, but you would be risking much less capital for this trade. If you lost the leveraged trade, you would be losing $2.500 which would actually be more than your initial deposit. This happens because with 50:1 leverage you are actually trading a position worth $50.000 (50 x $1.000) and the higher the potential reward – the higher the risks associated with it.
Some brokers, however, provide negative balance protection and as such, you wouldn’t be liable to pay back the broker for any losses exceeding your invested capital. Also note that while you are trading with leverage, there is a margin requirement you need to meet at all times, or the trade will be closed automatically by your broker in order to prevent extreme losses. This is why you need to monitor your trade at all times. In case the market moves against your position you will need to invest additional funds to avoid the forcible closure of your position if there aren’t enough funds to cover the loss. The markets could bounce back at any time and if you don’t have enough free margin available in your account, your trade will be closed and instead of realizing a profit, you could lose your entire invested capital instead.
Beware of volatility
Volatility and leverage are both favorable conditions for traders and especially those who trade currency pairs since currencies are extremely volatile and offer high leverage ratios. However, increased volatility in the markets can sometimes be catastrophic for a leveraged trade due to how quickly you can run out of margin when using high leverage.
Therefore, you need to consider your position size or how many lots you are going to be trading in order to not risk a large percentage of your account on a single trade. The risk to reward sweet-spot ratio is 3% of your total account size. So, if you have an account with a $1.000 deposit, you shouldn’t risk more than $30 (0.03 x 1000) on each trade.
Surviving the markets is a war of attrition where your main objective should be to wear down your opponent slowly and consistently – trade by trade. This way, you have enough opportunity to come back when (and not if) you face the eventual losing streak. If you go all-in, using your more than 10% of your account on each trade, you will not be able to sustain a series of losses and you will run out of funds sooner rather than later.
It all comes down to patience, dedication and persistence. How you prepare and how much you are willing to invest and risk on every single trade is up to your discretion, but you should always ensure that it’s worth taking the risk for the potential reward.