Leverage Trading Pros and Cons

Leverage trading offers traders the opportunity to amplify their positions by borrowing funds, potentially increasing both profits and losses. While this strategy can significantly boost returns with a relatively small investment, it also carries heightened risks that can lead to substantial financial loss. Understanding the pros and cons of leverage trading is essential for anyone looking to maximize gains while managing potential downsides.

In this article, we'll explore how leverage works, its advantages for traders, and the potential pitfalls that must be navigated carefully. Whether you're a seasoned investor or a beginner, gaining insight into this high-reward, high-risk strategy is crucial for making informed trading decisions.

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What is Leverage Trading?

Leverage trading means that you amplify the amount of risk you can take with any given margin deposit to establish a larger trading position. The higher the leverage ratio you use, the larger the trading position you can hold in your margin account.

Keep in mind that the more trading leverage you apply to your positions, the more risk you incur. For example, a $100 initial deposit could be wiped out with a small adverse move in the forex currency pair if you use a high amount of leverage. By the same token, if the market responds favorably, then your position’s profits will be magnified by the amount of leverage used when establishing the position for margin trades.

How Does Leverage Trading Work?

As an example of how leverage trades work, if you take a leveraged position at a forex leverage ratio of 10:1 with just $100 placed on deposit with your online forex brokerage account as margin trades, then this will allow you to establish and control a $1,000 trading position.

If you decide to use a higher leverage ratio of 100:1, then that same $100 deposit can let you control a trading position of $10,000, and so on. Always remember that leverage is rather like a double-edged sword since you will amplify both your trading gains and losses if you use it when trading forex. 

The amount of leverage you can access in the forex market dwarfs the leverage available in the stock and commodities markets. Depending on the jurisdiction where you live, you may be able to leverage forex positions by as much as 500 or even 1,000 to 1. In contrast, U.S. stocks can only be leveraged at a relatively puny ratio of 2 to 1, and commodities traded on U.S. futures markets can only be leveraged at 10 or 20 to 1. 

Leverage vs. Margin

Leverage determines how much you need to put on deposit with your broker to hold a particular forex trading position, while margin is the amount of money that you actually put on deposit with your online broker. You basically employ margin to create leverage.

Leverage is generally expressed as a ratio of the amount of a trading position you can control with one base currency unit. In practice, this ratio looks like X:1 where X is the amount of a position you can control with 1 unit of your base currency. If your base currency is U.S. dollars and your leverage ratio is 100:1, then you can control a $100,000 trading position with just $1,000 placed on deposit as margin.

In contrast to the leverage ratio, the margin requirement of a given position is typically expressed as a percentage. The inverse relationship between leverage and the margin requirement can be seen in the following equation:

 
Leverage = 1 / Margin Requirement

If you were able to use a leverage ratio of 100:1 at your broker, then your margin requirement would be:

100 = 1 / Margin Requirement

Margin Requirement = 1/100 = 0.01 = 1.0%

You might also want to compute the amount of a position you can control with a given amount of “required margin” or the amount of money you actually need to deposit. You would do this using the following equation to calculate the controllable position size:

Controllable Position Size = Required Margin / Margin Requirement

Using the previous example of a 1% or 0.01 margin requirement and a required margin amount of $1,000 substituted into the above equation, you’d get: 

$100,000 = $1,000 / 0.01

This result means you can have a controllable position size of $100,000 if you put $1,000 on deposit as margin assuming a margin requirement of 1%. 

Pros of Leverage in Forex Trading

Using leverage when trading currencies has some advantages, including those listed below. 

Increased Profits

The main advantage of using leverage in forex trading is that you can control a position that is larger than the amount of money you place on deposit with your broker. If your trades end up being profitable, which is never guaranteed, then your profits will be amplified over those of an unleveraged position by the amount of leverage you used. 

Boosts Capital Efficiency

You can use your existing trading capital more efficiently by using leverage since you can control larger trading positions with a given amount of capital to use as a margin deposit. This lets you get started trading currencies with very little initial money. 

Combats Low Volatility

The forex market exhibits relatively low volatility compared to some other financial markets, like the stock market for example. Using leverage lets you amplify the impact of movements that do occur on your trading results. 

Cons of Leverage in Forex Trading

Using leverage when trading currencies also has some disadvantages, such as those listed below. 

Potential for Heavy Losses

Your losses will be magnified by the amount of leverage you use. This turn of events can quickly decimate your trading account, so you’ll probably want to use leverage prudently. 

Constant Liability

Leverage involves a constant liability since all leveraged gains and losses must be paid off for you to continue trading in your account after a position is closed out.

Increase Risk of Closeouts or Margin Calls

Using leverage increases the risk of an automatic closeout of your losing trading positions by your broker or of you receiving a margin call from your broker if the net value of your forex trading positions falls below your margin account’s balance. 

Master Leverage Trading with These Top Forex Brokers

If you’re interested in trading forex using leverage, then you will want to open a margin account with an online forex broker. Benzinga has taken the guesswork out of finding a reputable forex broker by making the following comparison table of potentially suitable forex brokers that allow leveraged forex trading. 

Using Leverage as an Investment Strategy

Leverage trading is one of the most popular methods of trading for forex traders. However, there are both pros and cons to using leverage when trading forex. One of the biggest advantages of leverage trading is that it can magnify potential profits. Since traders can trade with more money than they actually have, they may be able to make more money on successful trades. Additionally, it allows traders to enter larger trades with smaller amounts of capital, which can also lead to greater profits.

However, there are also significant risks associated with leverage trading. One major disadvantage of leveraging is that losses can be magnified as well. If a trader uses too much leverage and makes a bad trade, they could lose more money than they have in their account. Additionally, this type of trading requires careful risk management as markets can be volatile and unpredictable. Therefore, it is important for traders to manage their risks carefully and use stop losses to minimize losses.

While there are significant benefits to leverage trading in the forex market, it is not without its drawbacks. Traders need to be aware of the risks associated and take the necessary precautions to protect their capital. Proper risk management techniques and a sound trading strategy can help mitigate the risks and allow traders to take advantage of the benefits provided by leverage trading.

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