March 13, 2020

Practice shows that many traders and investors do not understand very well what leverage is and what benefits and risks it carries. In fact, this leverage is just a tool that multiplies opportunities for a trader.

For those who don't know, let's explain: a credit leverage is the amount of credit funds that a broker provides a trader with for making transactions on the market, automatically and without any collateral. Thus, if the maximum leverage ratio is 1:1000, having $100 in the account, the trader can make transactions for purchase/sale of foreign currency or other financial instruments worth 1,000 times more than their own funds, that is, $100,000.

 

In case of luck, the trader's profit will grow proportionally to the leverage.  But the losses will increase in case of failure as well. This is what has divided traders into two camps. In the opinion of the first, a high leverage ­leads to the inevitable loss of the deposit, in the opinion of the second, this is an excellent tool for trading, which makes it possible not only to increase your profit many times, but also ... seriously reduce trading risks. That is, the leverage is a tool like many others, like, say, a hammer. And those who know how to use it correctly can build a whole house, and those who do not, will be left without fingers very quickly.

Here is another example, even more obvious. Your car has a capacity of going at a speed of 200 km/h. But this does not mean that every time you leave the house, you immediately press the pedal to its limit.  No, you will go using the potential of the car for a quarter or a third. But when it is necessary and the situation allows, it is possible to go faster.

One should clearly understand that the size of the leverage does NOT affect the level of risk! The risk is managed by traders themselves, when they open a position of this or that volume!

Manuals on money management often write that professional traders never risk amounts exceeding 5% of their deposit.  The statement is controversial, and it all depends on the strategy that a particular trader uses. But what is beyond doubt is that no trader in their right mind will use all 100% of their capital in one single transaction, as this is a guaranteed way to lose all their funds quickly.

And here is a concrete example (in practice, it is also necessary to consider broker's commission and swaps when you do the calculations).


Let's say that you currently have $10,000 on your trading account and, as the money management tutorials recommend, you decide to open a trade on the EUR/USD pair with a volume of 5% of your capital, i.e. $500. If you do not use the leverage, at the rate of 1.1 dollars for 1 euro, you can buy, round off, €455 for these 500 dollars.

At the end of the day, you close the trade and change your 455 euros back to dollars. And, if the European currency has grown during the day, say, 100 points, to 1.1100, your profit will be 5 dollars and 5 cents. Which, in general, is not bad.

But with a 1:1000 leverage the same $500 can buy you €455,000 instead of €455. And your profit, respectively, will not be equal to $5.05, but $5,050!


Agree that this is not just good, but amazing: by investing only $500 in a transaction, you can earn 10 times more in one day! But... this is only possible if the price went in the right direction for you. And what if, instead of starting to grow, it started to fall?

And here the opponents of a large leverage celebrate. Oh yes, if you trade without leverage, the euro should collapse from 1.1000 to zero for you to lose your $500. But even in this case, you will still have your $9,500 in your account. And with a 1:1000 leverage, a 200-point drop in the price is enough to make your $10,000 disappear without a trace.

But! This is where knowledge of trading tactics and strategies in financial markets comes into play. Leverage, creating a huge reserve of available funds, will allow you not only to build up a losing position in the calculation of a trend reversal, but also to diversify the risks in a variety of ways that the brokerage company NordFX provides to its clients. These include opening hedging transactions on other trading instruments - stocks, indices, currency and cryptocurrency pairs, oil and precious metals, PAMM accounts, and automatically copying transactions of other, more experienced, traders in the Copy Trading service, or, for example, trading using robot advisors.

Another very important aspect is the deposit that you have. We used the amount $10,000 in the example above. And what  if you only have $100 or even $10? This is the minimum deposit amount on the Fix account with the NordFX broker. Can you then trade Forex without using leverage at all?

Of course not!

Recall that 1 lot is equal to $100,000, and the minimum transaction size for most brokers is 0.01 lots, that is, $1000. That is, you will need to use the 1:100 leverage to open at least one trade with a deposit of $10. And there is no question of hedging risks in this case. But the 1:1000 leverage makes it possible to open up to 10 different transactions with a volume of 0.01 lots, and then one can start talking about a trading strategy and hedging trading risks.   

And now let's sum up the above. The main benefit of the leverage is that it gives the trader the freedom to maneuver in the market. At the same time:

The larger the leverage ratio is, the more are the free funds you have!

And this:

  1. Significantly reduces the risks. After all, even with a small deposit, you can add a variety of trading tools to your investment portfolio. And while one position will be in a drawdown, the other may go into profit.
  2. Allows you to increase profitability and diversify risks by using several trading strategies at the same time.
  3. Increases the probability of a successful exit from the drawdown by varying the traded volumes and increasing positions when the price moves against the trader.

And once again, we repeat three axioms that cannot be doubted:

  1. The amount of leverage does NOT affect the level of risk!
  2. The trader manages the risk when he or she opens a position of this or that volume.
  3. The leverage ratio is just a tool, and it depends only on the knowledge and skills of the trader whether it can benefit or damage the trader.


« Useful Articles
Follow Us