An important reason why many investors are drawn to forex trading is the higher leverage that they can get when compared with stocks. Even though most traders have heard of the term “leverage”, only a few are conversant with its true meaning, how it works, and the effect it has on their investments.
The concept of leverage trading involves using other people’s funds to enter a transaction. This can also be adopted in forex markets. In this guide, we will provide an insight into what leverage trading is, how it works, and why forex leverage trading can be a Double-edged Sword. So, keep on reading!
Understanding The Concept of Leverage
Leverage is a strategy that involves borrowing a specific amount of funds for investment purposes. In forex, these funds are borrowed from a broker. Forex trading supports high trading and traders can build up a huge sum of funds for an initial margin.
When you borrow funds from a broker, it is possible for investors to trade large positions in a currency. With this in mind, it is safe to affirm that leverage magnifies the returns on investment from a positive movement in an exchange rate of a currency.
Yet, leverage is a double-edged sword, which implies that its upsides are matched by its drawbacks. In an unfavorable movement of a currency’s exchange rate, it can magnify losses. For this reason, it is imperative that you understand how leverage works and how to manage it. There are also risk management strategies that can help mitigate forex losses.
How Does Leverage Trading Work?
Trading on leverage is not a bad thing to embrace if you know what you are doing as you acquaint yourself with the risks. However, if that is not the case, it can be very risky, exposing you to higher potential losses than you can afford to.
You can choose to trade on margin, which represents the funds that are borrowed from a broker to purchase a security while using other securities in your brokerage account as a form of collateral. An example will explain this better.
There is $30,000 in your brokerage account and you wish to invest in a company that is currently trading at $30 per share. You can afford 1,000 shares with the cash you have. By using margin, you borrow $30,000 from your broker. This allows you to increase your purchasing power to 2,000 shares. With this, you can multiply your gains and losses.
However, if the share price increases to $50, that implies that you make a profit of $20,000 with cash at hand. However, with margin trading, this increases to $40,000. In this way, your profit has been magnified.
On the other hand, if the share rise drops to $40, you would lose $10,000. With margin trading, this loss increases to $20,000. If the share price drops to $15. This implies that you lose $15,000 or 50% of the cash invested.
With margin trade, this increases to $30,000 or 100% of the cash invested. Since you have to pay back the broker, you exhaust all the returns to pay back the money borrowed.
If the share price drops further to $10. You will lose $20,000 or 66.7% of the cash invested. With margin trading, you lose $40,000 or 133.33% of the amount invested. This implies that you would still owe the broker money after selling all your shares.
Final Thoughts
With the example illustrated above, it is clear that while margin trading can improve your position during transactions by increasing your purchasing power, it can also expose you to a higher level of risk. However, the advancement in technology has made it easier and more important for investors to adopt risk management strategies. After all, leverage trading is a double-edged sword, capable of magnifying your profits and losses to an equal extent.
