What is leverage and why is it so important for traders?

The diversity of financial mechanisms and the variety of financial products allow investors to set up many trading strategies. However, to limit their capital requirements, traders favor a particular approach: margin trading (made possible by leverage). Particularly useful for experienced traders, leverage can also be particularly dangerous for beginners. Here are some explanations to fully understand how it works.

What is leverage?

In the financial framework, the leverage effect is a mechanism to amplify the trader’s investment capacity. Both when buying and selling, leverage allows for larger trades, the amounts of which may exceed the money tied up in the trading account.

The valuation of a trading account is divided between the money used to finance open positions (the locked-in margin) and the money available to fund the opening of new positions (the available margin). When the margin levels required by the broker are not covered by the funds deposited in the trader’s account, the trader experiences a “margin call”. Then the trader must close all or part of his positions to reduce the need for margin or add money to his account to increase the margin. If the trader does not take these actions, the broker can automatically close open positions to reduce the risk exposure.

How does leverage work?

When trading financial products with an online broker, the use of leverage comprises a debtor-to-creditor situation. The debtor is the investor, and the creditor is the broker. 

The broker indicates the money needed to cover the risk of a position (the margin). For example, a required margin of 1 in 50 means that it takes € 1 of available margin to finance the opening of a position of € 50. In this example, the required margin is 1/50, so the maximum leverage allowed is 50.

From a practical point of view, a leverage of 50 means that the trader’s gains and losses will be multiplied by 50. Thanks to the leverage, instead of losing or gaining 1 € on the trading position, the trader will now lose or win € 50 for this same variation.

Typically, more seasoned traders allow themselves significant leverage for their short-term trading. 

Most financial derivative products come with leverage. However, two main instruments remain emblematic of this trading mechanism. These are index futures and CFDs. To allow their clients to take advantage of fluctuations in the currency market, Forex brokers offer significant leverage. However, it should be handled with caution. A leverage calculator is ideal for accurate calculation of the amounts for opening a trading position according to lot size and the broker’s leverage enabled.

Manage the risks of leverage

While leverage represents a way to increase your potential profit, remember that it also increases your risk level. For this reason, having the right risk management rules in place is essential. And especially when leverage is used in the Forex market. Here are some of the top orders that can improve your leverage management.

Stop-Loss Orders

Stop Loss orders limit the trader’s losses when the market moves against them. The trader can use this order to set the price level beyond which he wants his position to be closed automatically.

Trailing Stop Loss orders serve to limit the trader’s losses when the market moves against him. But that’s not all. When the market moves in its favor, the Trailing Stop Loss order also secures a portion of the trader’s gains by following favorable price movements.

Guaranteed Stop Loss Orders

Finally, Guaranteed Stop Loss Orders work the same way as Stop Loss Orders. Except that they allow you to set an absolute limit to your potential losses on a given trade. They assure you that your trade will be closed at the specified price. To take advantage of this additional security, the trader must pay a commission displayed on the order ticket.

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