What is leverage in Forex trading?
Leverage is a method of trading and investing in which an investor will use borrowed capital in order to act as a springboard for greater possible profits and returns that could arise from a financial investment.
The term leverage can also be used to distinguish and indicate the debt level a business or company adopts in order to finance its equity and assets. For example, if a firm, real estate equity or investment has vast amounts of leverage, this signifies that there is a greater amount of debt in relation to profits.
So how does leverage work exactly?
- Leverage works by taking borrowed capital to fund an investment, with the sole intention of maximizing and boosting the potential profits of that investment.
- Leverage is used by investors as a way of increasing their buying capabilities within the financial markets.
- Leverage can be used by businesses as a method of asset financing. In other words, rather than selling stocks to earn money, firms have the ability, through leverage, to invest in financial projects as a way of boosting a return on capital.
“A company formed with an investment of $5 million from investors, the equity in the company is $5 million; this is the money the company can use to operate. If the company uses debt financing by borrowing $20 million, it now has $25 million to invest in business operations and more opportunity to increase value for shareholders. An automaker, for example, could borrow money to build a new factory. The new factory would enable the automaker to increase the number of cars it produces and increase profits.”
How is leverage used in Forex market trading
Within Forex trading, leverage is usually obtained from a regulated broker. Forex market trading gives investors the opportunity to use high levels of leverage.
The common leverage ratio within the Forex markets is 100 to 1; therefore, should an investor have 100 Euros in their account, they have the ability to trade anything up to 10,000 Euros. Some investors think that the Forex markets offer high levels of leverage because they acknowledge the fact that by accurately directing their trading account the risk levels can also be directed and controlled appropriately.
When a financial instrument like a commodity, currency or security is bought and sold straightaway this is known as a spot market. Additionally, Forex markets have higher levels of liquidity when compared to other financial markets like the real estate investment markets.
What does the term pip mean in Forex trading? A pip is a fundamental principle of foreign exchange investing. Forex investors trade currency pairs in which the value of each currency is dependent upon the bid and ask quote and the exchange rate of each currency. Currency pairs are commonly given in four decimal places which therefore means that the minimum change in the exchange rate of any currency pair quoted to four decimal places is 1 percent or 0.0001. Let’s take the EUR/USD currency pair as an example. If the EUR/USD pair drops by 200 pips from 1.1300 to 1.1100 then this means the exchange rate has moved by 2 cents.
Forex leverage has its risks
Leverage in the Forex markets has its associated risks. It amplifies equally the margins for profits as well as for losses. The higher the level of leverage the greater the liability.
Here’s a quick example to help demonstrate the risks associated with Forex leverage.
Two traders have a total trading capital of 20,000 USD, and the broker they use necessitates that they deposit a 1 percent margin. Following some research, the two traders decide that a particular currency pair will hit a top and therefore drop in value.
The first trader selects 100 times real leverage on the trade whereas the second trader picks a 10 times real leverage on the same trade. Now, should the traded currency pair surge upwards instead of dropping then the first trader will lose a greater percentage of his/her trading capital compared to the second trader who will lose a smaller, less damaging percentage of their trading capital.
As a vehicle for larger investments a leverage can be versatile and complex. As aforementioned, leverage in Forex trading amplifies both profits and deficits. Leveraged investments which do not go as planned result in greater losses compared to an investment made without leverage. Firms can use leverage as a way of promoting shareholder value, if for whatever reason however this does not work then the cost of interest and the damage to credit can diminish shareholder value.
When used sensibly and managed carefully leverage in Forex trading can give an investor the opportunity to maximize capital return. As we have seen leverage carries the same risk for both profits and losses, so it pays off for traders to be careful and to conduct thorough research when applying high leverage to Forex trades.
“Through balance sheet analysis, investors can study the debt and equity on the books of various firms and can invest in companies that put leverage to work on behalf of their businesses. Statistics such as return on equity, debt to equity and return on capital employed help investors determine how companies deploy capital and how much of that capital companies have borrowed. To properly evaluate these statistics, it is important to keep in mind that leverage comes in several varieties, including operating, financial and combined leverage.”
“Fundamental analysis uses the degree of operating leverage. One can calculate the degree of operating leverage by dividing the percentage change of a company’s earnings per share by its percentage change in its earnings before interest and taxes over a period. Similarly, one could calculate the degree of operating leverage by dividing a company’s EBIT by its EBIT less its interest expense. A higher degree of operating leverage shows a higher level of volatility in a company’s EPS.”
A few tips to keep in mind when using leverage
- Traders who have little or no experience in trading Forex with leverage could benefit from using a demo or practice account at first. By using such a practice account, a trader can slowly test the Forex waters by using trial and error and seeing what works best.
- The use of a strategic stop-loss order can help curb losses and preserve any profits because the broker will either purchase or sell the stock at a specified time.
Risk Disclaimer: CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 79.28% of retail investor accounts lose money when trading CFDs with this provider. The information contained in this market review should not be construed in any way, as containing investment advice and/or a suggestion and/or solicitation for any trading activity and financial transaction. There is no guarantee and/or prediction of future performance. EuropeFX, its affiliates, agents, directors or employees do not guarantee the accuracy and validity of any information or data made available and assume no liability as to any loss arising from any investment based on the same. Trading Forex/CFD’s carries a high level of risk and can result in the loss of your whole investment. Forex/CFD’s are leveraged products and therefore Forex/CFD’s trading may not be appropriate for all investors. It is recommended that you do not invest more money than you can afford to lose to avoid significant financial problems in the case of losses. Please make sure you define the maximum risk acceptable for yourself.