The usual definition for leverage is “having the ability to control a huge amount of money using very little of your own money and, at the end, borrowing the rest”. And, like everything, it has two sides.
The leverage is a term we can usually find in the FOREX trading.
The FOREX trading has become one of the most significant ways to manage and earn money, and it is probably one the most liquid financial markets in the world of finances. It can bring you significant profits and benefits in the long term.
There are usually a couple of questions that a lot of people in the FOREX trading do. For example, “Is the FOREX market profitable?” and “What does it make it profitable?”
You, as a trader, need to know that, if you are trading with FOREX, there will be some losses and not all traders will result in a profit. This happens because the FOREX market is a high- risk trading market; if the risk is high the potential for FOREX profit will be high too.
Once we get into this world, there will be a few terms which you truly need to know, to find your trading strategy and that kind of stuff.
One of those terms is “leverage”
Usually, leverage gives the opportunity to enlarge all its profits to the investor or trader. But, on the other hand, leverage can also amplify all your losses as an investor in case of a wrong trade.
Types of leverage
- Operating leverage: this type of leverage studies the impact of operating fixed cost. The operating leverage is just the profit or loss that can ascend all that due to the previously involved fixed cost. It can be distinguished as a firm’s position or the ability to magnify the effect of changes in sales.
- Financial leverage: the financial leverage studies the distinguished impact of any kind of financial cost. It can be defined as the percentage change in EPS related to an already given percentage change.
This leverage is one of the most important because it helps us access the financial risk. It also assists in reaching trading on equity. It is important to know that trading on equity only exits when the return on the investment you made is higher than the cost of debt.
- Combined leverage: this one rises due to the involvement of both kinds of fixed cost (operating leverage and financial leverage). It also studies the combined effect to the fixed or operating leverage and financial cost or financial leverage.
Even if leverage is used in many trades, it is mostly used in the FOREX market. In fact, sometimes it is weird to see a broker offering leverage in the ratios of 200:1, 50:1 and 100:1. And that is why the leverage is important in the FOREX trading.
But just as everything, it has pros and cons that you need to evaluate. We will highlight the main reason why you should use it, but also why you should be careful with it.
- The main advantage is huge profits.
The leverage allows the trader to increase the scale of their profits. With leverage, multiple small investors get the opportunity to see large profits in a really short time if they are having a good day.
- The main disadvantage is potentially catastrophic losses.
The truth is that using leverage is a huge risk, especially if you are a beginner in its use and in the trading world, not just FOREX.
That happens because, in the FOREX market, the possibilities of having good profits are the same as having big losses. The leverage puts the trader under risk and pressure because, if the trades that he makes are not good enough to pay, the leverage will take the trader into a hole of losses and no gains.
Now that you know that the leverage can be as bad as it can be good, the best way to find the good side of it is to use it in the right way.
Tips to use leverage in the right way
- First, you need to cap all your losses: if you are trying to take big profits, you need to learn how to keep your losses as small as you can.
- Use strategic stops: This one can be used to ensure that losses are capped and you can protect your profits.
- Use the leverage level with which you feel comfortable: if you are a cautious trader , use a lower leverage; for example, 5:1 o 10:1
- Keep Calm: Don’t try to get out of a position where your losses are big by trying to get a higher leverage.
The leverage can help you as long as you know how to use it.