Why Leverage Isn’t Always a Good Thing

LeverageLeverage has always been part of trading. Ever since man started using mediums of exchange (see: money), some people has found themselves in a specific position; they don’t have enough funds to acquire certain assets, but know people who do. This is how trading with leverage was born, by the ability to enter debt with other people in order to increase your purchasing power. It’s been a practical strategy to quickly augment your trading capacity.

However, whenever someone says the word “debt”, there is a certain caution to be had. And, even if FOREX brokers offer a different kind of leverage, as we’re going to learn soon, you still need to be careful.

What’s Leverage?

You might have guessed from our first words, but “leverage” refers to using money that’s not yours in order to purchase or trade in higher numbers than what you could with just your capital.

Some websites define leverage as “taking on debt”, and this is not too far from the truth. Traditionally, leverage is borrowing money but with the previously mentioned intent.

For example, let’s say you’re using a 1:5 leverage.

That means that per every $1 you invest, you’ll be able to spend $5. This way, you’re able to purchase a stock that’s worth $2,500 by investing $500.

Leverage In The FOREX Industry.

Remember when we said that leveraged trading is different in FOREX?

Well, that’s because of one important factor; you’re not trading directly by yourself.

In FOREX trading, you use what’s called a broker, which is nothing more than a company you hire so that they can perform the trades for you following your orders.

So, what’s the difference in this leverage?

First off, we have that leverage in FOREX is much higher than usual leverages.

While traditional markets offer leverages around 1:5 or 1:10, FOREX brokers place theirs around 1:50, some even go as far as 1:500 or unlimited leveraged trading.

While some people may get excited over that, others are probably repeating the word “debt” in their minds over and over.

That takes us to our second difference; FOREX leverage is not taking on debt.

While it’s also called leverage, you’re not expected to pay any back any credit.

What you are expected to do is to not deplete your minimum margin. That is, the smallest amount of money you need to keep your trade; in a $200,000 trade using 1:100 leverage, that means you can’t find yourself under $2,000.

The other condition is that your money is used as collateral.

How Can Leverage Be Bad?

Well, the key to understand the issues with leverage is the previous sentence.

Let’s say you’re trading with leverage, we’ll use 1:100 for this example. That ratio means three things:

  1. You’re able to trade $100 per every $1 in your account.
  2. If your pair goes up 30 pips, and we’ll place each pip at $10, you’re going to earn $30,000 instead of $300.
  3. If your pair goes down in the same volume, you’ll lose $30,000 instead $300.

You’re not expected to pay back your broker, but those loses are 100% yours.

The fact that part of your position is financially split doesn’t mean that loses will be as well.

That’s what it means to have your money as collateral.

What Are The Consequences?

Well, you just read the most obvious consequence.

While the broker does cover your trade, it won’t cover your loses. The result is that your losing trades are going to be much more significant.

This brings upon us a real danger that is losing money faster than we notice.

That also entails depleting our funds way, way faster than we would otherwise.

What’s worse, such numbers may result in panic and the use of bad strategies to compensate. There’s a certain mentality that, when you fail, you need to double your position to compensate.

The Dreaded Margin Call.

This might be the worse consequence when trading with leverage in the FOREX market.

Remember when we said that you couldn’t fall under your margin? Well, leverage can make you do so very quickly, and the results aren’t pretty.

What happens when you fall under that margin is that you get an alarm. And the meaning of that alarm is that your broker is going to close any positions it deems as too risky.

And, guess what? You don’t really get to choose which position they close.

They can close anything, even that huge position that you had all your hopes on. Not even profitable trades are safe.

That’s the other side of the coin when it comes to leveraged trading.

However, that doesn’t mean that you shouldn’t use leverage. By all means, do so if you feel comfortable with its implications and your own position.

Leverage isn’t a good or a bad thing, but it amplifies good and bad outcomes.

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