Often presented as the culprit of the losses of novice investors, especially in Forex, leverage is in fact a double-edged sword that can allow you to multiply your profits. So how do you control leverage to make it your ally? But first of all, what exactly is leverage and how does it work?
What is the Leverage Effect? Definition
THEleverage on the stock market is a tool that allows the trader to increase his investment capacity by mobilizing only part of his total capital.
Concretely, thanks to the leverage effect, you can open positions up to 1 times the value of your capital.
How Does the Lever Effect Work? Example
Leverage is noted as: 1 leverage: 50 or 1 leverage: 100, for example.
A leverage of 100 (1: 100) means that for a capital of 100 euros, you have the opportunity to trade for an amount of 10 000 euros.
This is a definite advantage and, while it is possible to trade without leverage, many traders prefer to take risks and see their gains potentially increased tenfold.
Which Financial Instruments are Characterized by the Use of Financial Leverage Effect?
Trading with leverage is practiced in many markets, such as stocks, Forex, commodities, indices or even bonds. Forex leverage, for example, can go up to 1: 500 depending on the broker.
Likewise, there is more than one leveraged product. These include futures contracts, or futures, currencies, CFDs, or options.
Forex and Leverage Effect: Calculation
Forex is typically a highly leveraged market. Indeed, on the Forex market, lots are traded. Knowing that a Forex lot is worth 100 currency units, for example 000 euros, the individual trader uses either mini lots or micro lots, or trading with leverage.
To fully understand the Forex leverage effect, let's take the following example. With 1 euros in his trading account, an investor cannot trade an entire Forex lot. If he decides to use leverage of 000: 1, then he can take positions with a total value of 500 euros, or 500 times the value of his capital.
The maximum Forex leverage varies depending on your broker. It can go up to 1: 500, for example at Admiral Markets, a regulated broker FCA .
Which Leverage Effect to choose?
While it is easy to understand how to use leverage on the stock market to increase your earnings tenfold, it is on the other hand more difficult to determine which leverage to choose.
Indeed, even if we can estimate that the longer a position is, the lower the leverage will be, the best leverage will always depend on your trading strategy.
For example, a position trader usually chooses a leverage from 1: 5 to 1: 20. The scalper prefers a higher leverage, from 1: 50 to 1: 500.
To limit the risks, it is advisable to always train and test your strategy on a demo account before investing in real mode. A demo trading account allows you to trade under real market conditions but with fictitious capital, therefore without taking any risk.
Conclusion: Risks and Benefits of the Lever Effect
To conclude on the concept of leverage in trading, it is important to underline its intrinsic dual nature. Indeed, the leverage effect is a formidable tool which allows the trader to invest more while locking up less his capital. However, you should keep in mind that your gains, but also your losses, are calculated on the basis of the total value of your position and not on the basis of the amount you actually invested. This is why you can lose more than your original bet and why it is important to never invest more than you can afford to lose.