In the financial markets, leverage is used as a way of attracting potential investors. Leverage is used both in the stock markets and the forex markets. By comparison, the leverage in the forex markets is higher than that in the stock markets. The problem is that not many traders understand what leverage is and its effect on the financial markets.
Leverage is all about making use of other people’s money to carry out transactions. In the financial markets, investors get leverage at the cost of the forex or stockbroker. In this write-up, we explore the positive effects of leverage on forex and stock trading.
What Is Leverage?
Leverage refers to borrowed money for investing in something. As such, firms leverage their capital by borrowing money from financial institutions and other lenders. In the forex markets, this money is borrowed from the broker’s account. Although it doesn’t offer high leverages, traders in the forex market invest a small amount but are able to make a bigger investment. This helps them to build and eventually control huge amounts of money in the long run. The following are the two types of leverage in the financial markets.
1. Margin-Based Leverage
The oft-quoted leverage in the forex markets is the margin-based leverage. The formula for calculating it is as follows:
Margin-based leverage = total value of transaction / the required margin
Say a stockbroker requires you to deposit 2 percent of the transaction value to trade a standard USD/CHF lot valued at $100,000. The 2 percent is the margin and would require you to invest $2,000. You will have margin-based leverage of 100,000/2,000 or 50:1. If the margin requirement is 0.25 percent, you will have margin-based leverage of 400:1.
In the forex markets, margin-based leverage may have no impact on the risk. The fact that you are required to deposit a percentage of the transaction amount hardly has an effect on risk. Neither does it determine whether you make profits or not. That’s because an investor may choose to invest more than what’s required. That’s where real leverage comes in.
2. Real Leverage
Real leverage is the best indicator of whether an investor in the financial markets is going to make a profit or a loss. It is calculated by dividing the total transaction value by the trading capital. Thus,
Real leverage = total transaction value / total trading capital
Say your account balance is $10,000 and it’s your intention to make a $100,000 opening position or one standard lot. In this case, your real leverage is 10 times or 100,000/10,000. If you double the slot to $200,000 with the same $10,000 account balance, the real leverage is 200,000/10,000 or 20 times.
In the forex markets, margin-based margin represents the upper limit of the real leverage a trader can use. The truth is that a majority of traders rarely use their entire account balance as margin. Thus, the real margin is most of the time different from the margin-based leverage.
Risk and Opportunity: How Does Leverage Affect the Financial Market?
In the forex markets, risk is measured in terms of pips. Traders use the number of pips to determine the potential loss of the invested capital. Mostly, the loss isn’t more than 3 percent. Where the leverage exposes a trader to a 30 percent loss of trading capital, it would be necessary to reduce leverage by the same measure. Where traders are experienced in trading in financial markets, they would know how to maintain their potential losses close to the 3 percent margin.
It is also possible to calculate the level of margin a trader is going to use. If you have $20,000 in your trading account, could decide to trade the USD/JPY pair in 10 mini lots. Every single pip is worth $1 translating to $10 for in mini pips. That will be equivalent to $100 for 100 pips.
In this case, 30 pips would mean risking a loss of up to $30 for just one mini lot. For 10 mini lots, the loss would be $300. When extrapolated to 100 mini lots, the loss comes to $3,000. So if you have a $10,000 balance in your account and a maximum risk of 3 percent, it is advisable that you leverage a maximum of 30 mini lots, even if you are able to trade more.
Since leverage represents a risk, it is important that traders properly manage their trading accounts to avoid incurring huge losses. Usually, movements in forex prices happen in terms of pips or the minutest changes in any currency pair. These price changes could be on the lower side or otherwise. If on the higher side, then the gains will come a little at a time. Due to the risk represented by leverage in forex, investors are advised to trade sizeable amounts of money to realize substantial returns. For instance, a $100,000 transaction could result in either huge losses or profits.
Is Leverage Necessarily Good?
It is already clear that traders can use leverage to determine how profitable trading in a particular currency pair is going to be. However, due to the inherent risk, leverage could also lead to huge losses. Say you believe that a currency pair is going to move in a certain direction. As trading starts, the currency pair begins to move in the opposite direction. In that case, you are likely to end up with losses. That calls for the implementation of limit orders as well as stop orders for controlling potential losses.
What Should Traders Do?
As a trader in the financial markets, it is important to read the trading account agreement to know whether your losses are limited or not. There are a number of forex brokers that guarantee potential losses to be limited to your total investment. The rest are likely to charge you for any losses exceeding the amount you invested. Make sure you read and understand the fine print.
From the foregoing, it is clear that leverage has a huge impact on financial markets. It could determine whether you make losses or gains on your trades. Apart from being aware of the kind of leverage offered by a forex trader, you need to know if they have any guarantees on possible losses. As such, the best trading account is one that limits the losses to your total investment. Be wise!