Financial leverage is one of the most famous tools in Forex Trading, and forex trading leverage risks are just as well known. However, it's a double-edged sword that can provide immense satisfaction in terms of profits but can also pose many risks. The reason for this ambivalence can be traced back to its multiplier effect. In essence, leverage increases both gains and losses. Judging from this "small" detail, it is evident that it is necessary to take this tool with a grain of salt and evaluate its effects with the utmost accuracy. It is no coincidence that a common adage among traders is that leverage is only for experts.
How Financial Leverage Works
But... How does financial leverage work? Its operation consists of a... Concession. It allows you to move large sums despite the starting capital being small or insufficient. Leverage is represented by a ratio, which identifies the relationship between capital and generated volume. For example, if the leverage is 1:10, investing 100 euros will generate effects as if the investment were 1000 euros. Now, it is evident that if the volume increases tenfold, the same will be true for any gains but, at the same time.... For any losses.
An Example of Leverage in Action
Consider a hypothetical investment of 10,000, enhanced by a leverage of 1:100, with an assumed yield of 1%. Without the leverage, the profit would have been just 100 euros. Thanks to the leverage, which transformed the investment of 10,000 into a hypothetical 1,000,000, the profit is 10,000 euros. Now suppose the trade goes wrong: the loss will be 10,000 euros, equal to the real investment. A net loss of 100% is hard to digest.
Managing the Risk of Amplified Losses
The risk of disintegrating one's capital is therefore real. However, going into the negative is not. Of course, this is small consolation, but it is the broker itself that says enough. Specifically, the broker forces the trader to exit if the losses exceed the amounts present in the account.
Leverage should therefore instill a certain fear. This does not mean that it is a tool to be opposed, on the contrary. Also because there are countermeasures that can be taken to avoid the worst. For example, the stop loss. Exiting when losses are unsustainable (and the identification of unsustainability thresholds is determined by accurate money management work) means zeroing out the negative effects, or rather the drifts, of financial leverage in Forex Trading.
