Leverage, put in simple terms, is when a trader trades a larger volume than they normally would, using a limited amount of their own capital.
Leverage trading works by using a deposit (also known as a margin) that is funded by a broker. This provides traders with an increased amount of exposure using an underlying asset. Essentially, a fraction is put down on the full value of a trade, and a broker provides the rest as a loan.
However, there’s more to know about what leverage trading is in Forex.
The markets that leverage can be used on
Here’s 2 of the markets you can trade on using leverage:
Forex (foreign exchange) is the practice of buying and selling currency with the goal of making a profit. It is the most traded financial market in the world. The small movements involved in forex trading mean that many choose to trade with a leverage strategy.
A share is a single unit of ownership for a particular business and normally bought and sold on the stock exchange. Leverage can be used to open positions on 1000’s of shares, from blue-chip companies like Facebook to penny stocks (small public companies).
The benefits of using leverage
Using leverage can be incredibly powerful if you understand how it works and are comfortable using it. Here’s just some of the benefits of using it:
You only need to put down a fraction of the value of your trade to receive the same profit. Profits are calculated using the full value of your position so your margin can increase your returns when you successfully trade. However, it can also increase your losses on unsuccessful trades too.
Frees up capital
Using leverage frees up capital that can be used for other investments and trading opportunities. In the trading industry, this is formally known as gearing.
Shorting the market
Leverage helps to speculate market movements which in turn enables you to benefit from falling markets as well as those rising. This is known as shorting.
Understanding leverage ratios
Leverage ratio is a measurement of a trade’s total exposure compared to the margin requirement. The ratio will vary, depending on the market you are trading and the size of your position. For example, a 10% margin would provide the same exposure as a £1000 investment with just £100 margin. This gives a leverage ratio of 10:1.
Managing leverage risk
Whilst leverage can increase profits, it can increase potential losses as well. This is why you should carefully consider how much leverage you’re placing on your account. However, we should mention that trading this way always requires a degree of risk management.
That said, it’s quite possible to mitigate the adverse effects when trading with Forex leverage. Firstly, we don’t recommend trading an entire balance by opening a position with the maximum trading volume available. To help with this, most Forex brokers offer risk management tools to help traders manage their risks much more effectively. But, if you’re just getting started in your Forex journey, here’s three simple tips for you to keep in mind as you learn:
- Keep your position small.
- Use trailing stops to reduce any potential losses.
- Limit the amount of capital in each position you hold.
So, with a proper management strategy in place, leverage can be used successfully and profitably. Just keep in mind that you can set your leverage strategy so it’s in line with your financial goalposts.