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Leverage in Forex and other Financial Instruments

Leverage in Forex and other Financial Instruments

What is Leverage?

The forex market can be attractive to many investors because of several reasons but the main is leverage. Generally, leverage means borrowing capital as a fund source when investing to expand assets by amplifying return on investment thus carrying more risk. It is the amplification of the money deposited in the traders’ accounts. It gives them the ability to trade big positions by using small amounts of money.

Investors like the idea of borrowing capital to enhance profit, which is not available in other markets. These borrowed funds are not an amount that has to be paid after a certain time with interests. However, swap charges may be applied for holding the position overnight.

How to Choose the best Leverage for you?

The trader’s experience plays a great role in determining the leverage. Beginner traders are advised to choose low leverage. While the experienced investors seek higher leverage for more trading flexibility, especially when they are aware of how to mitigate the risk.

Exiting the position at the right time can mitigate the high leverage risk. This can happen by using the stop loss and take profit orders. Furthermore, it can save the trader from the need to inject more money when the position is losing. And this capital can be used in another new position, which can be profitable. 

What is Margin and Margin Call?

Before discussing the pros and cons of leverage, we need to explain the meaning of margin and margin call.

Trading on margin is used to increase investing power, by depositing a small percentage of the funds to lever investment. Margin is essentially the amount of money that the trader needs to put forward to place a trade in a bigger position. The required margin is the dollar amount needed by the broker to amplify your capital using leverage to be able to trade big.

Margin call happens when the investor’s equity as a percentage falls below the broker’s required margin. It is an order that will automatically liquidate the portfolio, at the time in which the capital falls below the threshold.

Leverage Advantages

It gives the trader the opportunity to trade with a low capital:

Previously when there was no leverage, only rich people used to trade with large capital. Nowadays, it is available to anyone with as low capital as $100 and sometimes less depending on the brokerage firm and the account type.

Leverage is interest-free:

There is no interest applied on the trades, except if the position was carried overnight, then swap charges may apply depending on the account type.

Magnifying profits:

Leverage increases your profit by magnifying your capital. By using the leverage of 1:1000, you can get the chance to trade with up to $100K while depositing $100 only. This gives you more flexibility in terms of the trading position and volume.

Leverage Disadvantages

Leverage is a double-edged sword:

Leverage helps investors to magnify return. However, if it was not used well, it will accelerate the losses. Thus, there is no reason to be afraid of leverage once the trader learns how to manage it. Leverage should not be used when considering the hands-off approach in trading.

Margin call risk:

Margin call has a risk because the client may have his portfolio liquidated automatically. This means that even the profitable positions will be liquidated as well. To mitigate this risk, the trader needs to keep on monitoring the portfolio and injecting money when required.

Final Words

Despite the cons that accompany leverage, the pros overweigh them. Therefore, dealing with leverage is a good idea, when the client knows when to exit the position.

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