Leverage is an aspect of the forex market, whereby traders and investors are able to control a large amount of money using very little money in trading. Ideally, it is the ratio of a trader’s capital relative to the size of credit offered by a broker, designed to increase potential returns while trading currency pairs.
Leverage entails borrowing a certain amount of money to be able to control much larger positions while trading. In the forex market, brokers offer credit to allow traders to trade big positions. For instance, with a capital of $1,000, a trader can comfortably place trades worth $100,000 on using a leverage of 1:100 in their trading account.
The leverage ratio, in this case, represents the debt to equity ratio. The greater the proportion of the debt, the higher the amount of leverage. Brokers often offer leverage as a way of shielding their clients from having to use too much equity to trade in the forex market.
Financial Leverage Uses
- Leverage is often used to expand an investor or traders’ asset base to be able to generate more returns on risk capital.
- Leverage also helps in increasing the potential of earnings
- Leverage is at times used for tax treatment as the interest expense is tax-deductible which ultimately reduces the cost of borrowing.
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Which is The Best Leverage
It is impossible to pinpoint ideal leverage to use in the financial markets. The ideal leverage will always come down to a trader’s trading strategy and what they wish to achieve in the market. Scalpers, as well as breakout traders, tend to use high leverage to be able to generate more returns on quick trades. Position traders, on the other hand, tend to use low leverage amount.
While some brokers offer leverage of as much as 1:400, the optimal leverage that most professional traders use is 1:100. In this case, by investing $500, a trader would be able to place trades worth $50,000.
Too Much Leverage is not Good
While high leverage can be attractive given the size of trades one can place, it can also be too risky. Leverage in forex is often referred to as a double-edged sword. What this means is that while it allows traders to accrue more returns, losses also accrue at a higher rate should something go wrong. While leverage has the potential to increase profits, it also has the ability to increase losses at the same rate as well.
How To Manage Leverage Risks
Given that leverage is a double-edged sword, the best way to ensure risks remain as minimal as possible entails:
- Using trailing stops to avert the accumulation of losses
- Trading using small positions
- Limiting the amount of capital on each opened position
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