Leverage, in simple terms, refers to investments made by use of borrowed funds. Investors that require additional capital or would simply like to increase their buying power may resort to using leverage to increase their positions and the gains from their investments.
Definition of leverage
Leverage, or gaining leverage is the act of borrowing money for investment purposes. The reasons behind leveraged positions may vary depending on the investor’s objectives.
The rationale behind leverage is the expectation of gains exceeding the interest payable for the loan. Leverages are often denoted as ratios. For example, a leverage of 2:1 means that a speculator has the opportunity to buy and sell trading instruments by twice the deposit’s purchasing power.
Why is understanding leverage important for traders?
- Strategically planning leveraged positions can lead to a substantially increased buying power and enable traders to benefit from highly probable setups.
- Leverage carries risk and misinformed risk-taking can lead to huge losses
- Leveraged positions require only a fraction of the capital contribution from the investor and many brokers offer significant leverage to investors
- Leverage can give the opportunity of risk mitigation if the investor has significant capital aside from the margin required by the broker
- Leverage in markets such as forex, where profit margins are small, can have more benefits and carry less risk than leverage in options positions
Leverage explained in more detail
Leverage is a simple tool for investors to increase their buying power prior to entering a trade they feel strongly about. For brokers it represents an opportunity to generate additional income through interest payments.
Brokerages will require margin before opening a leveraged position. Margin refers to the portion of their funds the investor needs to put down to qualify for leverage.
While leverage may be beneficial when the trade goes as planned, the losses will also be higher if the trade goes the other way.
Leveraged positions are often used by qualified professionals as they carry more risk than direct capital investments.
The details regarding leveraged positions and margin requirements will be provided by the broker.
Balancing the risks associated with leveraged positions is key in mitigating potential losses.
The broker will make a margin call by the time the repayment of the margin becomes due.
Leverage in forex trading
Forex trading without leverage is unimaginable due to the fact that changes in price are too small. High leverage enables traders to make substantial profits from even the tiniest volatility. Most brokers offer up to 500 to 1 or even 2000 to 1 leverages, however, bigger leverage doesn’t always mean the best. Leverage is a double edged sword and it can increase your losses just as easily as it can affect your profits. In countries where regulatory bodies have strict consumer protection policies in place, leverage is much smaller. For instance, in the UK, Australia, and Europe most brokerages offer up to 30:1 leverage to their traders.
FAQs on leverage
Is leverage risky?
Leveraged positions have increased upside and downside risk. If the trade goes according to plan, the investor will see increased gains – if not, losses will be amplified. Leverage represents debt and should be treated as such by investors.
How does leverage work in forex?
Leverage in forex works similarly to leverage in stocks and options. The main difference lies with the amount of leverage forex brokers offer. It is common to see 500:1 leverage in forex trading, due to the lower profit margins and high liquidity associated with forex markets.