What Is Leverage in Trading and How It Works

Leverage is one of the features available when you trade different financial markets, such as stocks, indices, commodities, or forex. The feature is a key one, and if you use it right, you can reap the benefits very soon. But if you’re new to all this, you may not know what it means and how you can take advantage of it. 

In this article, we’ll go into this term and see how leverage works. Let’s get started!

What Is Leverage in Trading?

Leverage refers to the act of using borrowed money in order to invest in security, stock, or currency. You borrow an amount of money that you use to invest in a market or asset with the purpose of making some profit. 

However, with leverage, you are only putting down a small capital amount, which then allows you to gain exposure to greater trading positions. 

When you begin forex trading, you will stumble upon leverage very often. The feature can be very attractive for investors who are not willing to take ownership of an asset or pay the full price of a share upfront. 

How Does Leverage Work?

With leverage, you are using a deposit, also called margin, to give you more exposure to underlying assets. What you do is put down only a small part of the trade’s full value, while your provider will give you the rest of the amount just like a loan. 

In case you lose or make a profit, it will be calculated based on the full size of the position and not the margin amount, even if you pay a small percentage of the whole value. The total exposure compared to the margin is also called the “leverage ratio”. 

Is Leverage Risky?

Just like any other feature, leverage has some risks. Leverage can lead to both great profits and losses, and you never know which one you’re going to get. Therefore, all traders should be very careful how much leverage they use when trading, especially if you’ve won several trades in a row and now you’re tempted to trade in much larger sizes. 

If you get a trade right, you can win and make a great profit. But if you get it wrong, you will also lose a lot of money.

Using leverage without a clear strategy in mind should be avoided. 

Leverage in Forex

Leverage is very common in the forex market, and it’s very likely to stumble upon a high leverage forex broker. Sometimes, the leverage can be as high as 100:1. 

A lot of traders think leverage is so high in forex because it is a function of risk. To put it simply, if one manages their account properly, it’s also easier to manage risk. Otherwise, the leverage would not be offered. And compared to less liquid markets, it’s easier to enter and exit trades at the wanted level due to how large and liquid spot cash forex markets are. 

Final Thoughts

Leverage can be great as long as you know how to use it right. However, if not used properly, it can lead to great losses.