The 3 biggest risks of leverage
While leverage can enhance your trading returns, it also comes with a series of disadvantages. Leveraged positions can lead to the complete wiping out of your trading balance, many traders over the years have found themselves victim to the negative effects of leverage, falling into huge financial losses.
For this very reason, it is important that you understand the risks of leverage before you make any decision regarding your investments.
The 3 biggest risks of leverage in trading
1- Measuring potential losses
The primary disadvantage of leverage is its ability to maximize losses when the going gets tough. Leverage extends your exposure to a particular position beyond your investment level, opening up the potential for greater gains.
When the markets move against your open positions, whether it be through margin CFD trading, spread trading, forex trading or any other leveraged transaction, it also means that you are required to match losses to the total trade, not to mention the interest costs associated with holding positions. With leverage for any period of time, and high commission costs applicable for each transaction.
If a leveraged long position in Company X is moved to a value of $1,000 with an initial investment of, say, $50, the trader has the opportunity to take a profit on the increase in value of the position of $1,000. However, if the value of the $1,000 position decreases by 10%, the trader becomes liable for a $100 loss in value even though his initial stake was only $50. In fact the liability on the downside is unlimited, and it is up to the trader to close out the losing positions before the broker does it for you, potentially at the expense of other profitable positions and your remaining trading balance.
2- Losses can exceed your deposit
Your exposure to leveraged trades is not limited to your trading volume only, nor is it limited to your trading account balance. Your broker may require more deposits to cover the stipulated margin requirements, known as a “margin call” to the extent that your liability extends to your trading balance. So it is imperative to make sure that you keep your trading within tight and affordable standards, and reduce your risk exposure whenever possible to avoid a leverage disaster.
One of the primary means by which you can reduce risk when trading with leverage is to set stop-loss orders, which are automatic orders that instruct the broker to close losing positions when they reach a certain point, and allow you to focus on other areas of your portfolio without having to constantly worry about the possibility of losses. terrific.
3- Raise financing costs
Long positions with margin products can become very expensive if leveraged financing costs exceed the potential earnings, so it is worth considering the costs you may incur the longer you hold the position.
Risks of Leverage in Forex Trading
For real leverage has the ability to increase your profits or losses by the same size, it is a double-edged sword. The higher the amount of leverage on the capital you apply, the higher the risk you will take. Remember that these risks are not necessarily related to leverage based on margin, although the latter can also affect you if you are not careful enough.
Trader A and Trader B each have a trading capital of say $10,000 and are trading with a broker that requires a 1% margin deposit. After doing some analysis, they both agreed that the USD/JPY pair had reached the top and should drop in value. So they both sell USD/JPY at 120.
Trader A chooses to apply 50x real leverage to this trade by selling $500,000 worth of USD/JPY (50 x $10,000) based on his trading capital of $10,000. Since USD/JPY stands at 120, one pip of USD/JPY for one standard lot is equal to approximately $8.30, so one pip of USD/JPY for five standard lots is approximately equal to $41.50. If USD/JPY rises to 121, Trader A will lose 100 pips on this trade, which equals a loss of 4150 USD. This single loss would represent 41.5% of their total trading capital.
Trader B is a more careful trader and decides to apply five times real leverage to this trade by selling $50,000 worth of USD/JPY (50 x $10,000) based on his trading capital of $10,000. $50,000 of USD/JPY is equivalent to only half of one standard lot. If USD/JPY rises to 121, Trader B will lose 100 pips on this trade, which equals a loss of $415. This single loss represents 4.15% of their total trading capital.
Summary
Leverage can be a great tool when used correctly, as it plays a pivotal role in the strategies of major investors around the world. With the right attitude towards risk, and a cautious approach to diversifying your trading portfolio, leverage can provide the rocket fuel necessary to double your investment capital and take your trading to the next level.
If you are still confusing the concepts of margin and leverage, see the article on the difference between leverage and margin, which will explain this difference to you in a simple way.
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