Leverage

    By
    Andrey Orlov
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    Leverage is a means of increasing your potential return on investment by using a capital loan or other financial instruments, such as margin, bonds, options or futures.

    The use of leverage allows a trader to control a much larger position with a smaller account than they would without leverage.

    A forex broker can effectively “lend” capital to a trader, who can then open a much larger position than they normally could. Leverage is a key part of money management.

    Leverage in trading

    If employing leverage forms part of your strategy, which is the case for most traders, it’s important to remember that its use not only magnifies your gains — it will also increase your losses if the market moves against you.

    Your leverage depends on the size of the trades you make relative to your account equity, and nothing else, as long as you don’t surpass the maximum leverage the broker allows.

    As an example, if a broker offers a leverage of 100:1, then a trader can purchase a standard lot of $100,000 with only $1,000.

    This means that a trader can trade with each pip being worth $10 and gain $100 with just ten pips. Without leverage, you would need $100,000 to achieve the same result.

    Other uses of leverage

    Leverage is the term used to describe the amount of debt a company can use to finance its expansion, which could be projects, assets or other activities. Debt is a cheaper way for most companies to pay for their growth but carries obvious risks. The alternative would be to increase their equity through new share issuances to raise capital. Companies that have a higher proportion of debt to their equity are said to be highly leveraged.

    A common form of leverage for almost everyone is taking out a mortgage to buy their home, as a mortgage normally entails a loan of some sort that may be up to ten times or more the borrower’s salary. The bank loans say, $100,000 to the home-owner, who earns $20,000 a year, to buy the property. This would be a leverage ratio of 5:1. The home-owner doesn’t see the money — the bank pays the property seller directly, while the borrower repays the bank over a fixed period, usually 20 or 25 years. Leverage through a mortgage is the only way most people can afford to buy a home.