How to Use Leverage in Forex Trading

Some time ago, financial leverage was wrongly considered the perfect tool, the only one capable of transforming a small amount of capital into a real treasure. This message, spread mainly for marketing reasons by unscrupulous brokers, was believed especially by beginners, those who approached Forex Trading for the first time. The impact with reality, for many of them, was very harsh. To the point that the authorities, at least the European ones, had to intervene, "capping" the financial leverage market, if it can be called that, by imposing a limit on their use. Today, with all the facts on the table, it is possible to look at financial leverage for what it is: a risky tool, but one that, if used wisely, can bring benefits. We talk about it in this article, describing its advantages and disadvantages, presenting a prudent and balanced approach to its use.

What is financial leverage

Financial leverage is the tool that allows you to exponentially increase the volume of your trades. Using financial leverage means effectively "pumping up" your exposure to the market. Leverage is regulated by a ratio, i.e., the ratio between the capital actually invested and the capital moved. For example, if the ratio is 1:10, the volume moved is 10 times higher than the capital actually invested. Obviously, the "effects" also change accordingly. Still considering a ratio of 1:10, and imagining an investment of 100 euros and a gain of 1%, the real gain will be 10 euros and not 1 euro. Nice, right? It may seem so, it's true, but all that glitters is not gold. You'll understand why in the next paragraphs.

The advantages of financial leverage

Rather than advantages, we should talk about "advantage". In fact, there is only one... And it's a big one. Financial leverage, at a theoretical level, and if everything goes well, really allows you to grow your capital quickly. It allows you to make gains 10, 20, 30 times higher than those that would be recorded without its use. In this way, it allows you to overcome a limit, which is mainly initial: the scarcity of capital. Those who start trading, and in particular Forex Trading, and do so as a beginner, usually don't have a sufficiently high capital on their side. This leads to two consequences: on the one hand, objectively minimal gains, and on the other, a certain discouragement in realizing that their efforts are collecting few results. Financial leverage allows you to overcome these limits, to avoid these unpleasant consequences. But we repeat, in theory and if everything goes as it should.

The dangers of financial leverage

And we come to the disadvantages section. Here too, there is only one: financial leverage is extremely dangerous. And the reason is intuitive: if it is true that potential gains increase exponentially, so do losses. Everything is calculated on a high trading volume. With the only difference that if you earn little, the issue has only psychological implications, if you lose a lot, the thing has concrete and dramatic implications. Let's revisit the example from a few lines ago, but assuming a loss, rather than a gain. So let's imagine a 1:10 leverage, a real investment of 100 euros and - this time - a loss of 1%. Well, without leverage we would have lost 1 euro, with leverage we would lose 10 euros, a tenth of the entire investment. Now, imagining a Forex Trading activity without defeats is utopian, not even the most experienced can achieve that, let alone a beginner. Hence the tendency of almost all beginners who use leverage to lose large sums of money. This pattern has been partially interrupted by European authorities, which have effectively prohibited high leverage. Because the examples we have made concern low leverage, but until a few years ago, leverages of 1:200 and 1:500 were seen around. Now the maximum leverage allowed is 1:30 (limited to Forex Trading), which is still a lot. Brokers have also taken steps to remedy this by imposing margin stops. That is, a functionality that blocks the trade and forces exit from the market when the loss in prospect (i.e., with the trade in progress) reaches a certain threshold.

How to manage financial leverage

So is financial leverage a tool to be abhorred always and in any case? Actually, no. If used with care, and under certain conditions, it can still prove useful. In particular, it would be good to follow four indications. Use leverage only when you have acquired sufficient knowledge. Beginners should stay away from financial leverage. Ideally, it should be used when the ratio of gains to losses has stabilized, in favor of the former, of course. This can take a long time. The problem with leverage lies precisely in the amplification of the effects of "bad" trades. Use leverage sparingly. In any case, leverage is a risky tool, regardless of the trader wielding it. Therefore, it is necessary not to abuse it, and use it occasionally. Preferably, when the market seems to hold many opportunities. In this regard, Warren Buffet's quote applies: "When it rains outside for hours, don't put out a thimble, but a bucket". Use low leverage. The rules allow financial leverage of 1:30. Many see this rule as an imposition, since in the past they traded with leverage up to ten times higher. The advice, however, is to act with even greater caution, and prefer lower leverage. Even 1:10 can give a lot of satisfaction. Accompany the use of leverage with money and risk management tools. Leverage has a lot to do with money and risk management tools. Leverage poses risks, while these tools reduce their effects. So if you really want to use leverage, get yourself a parachute. A good parachute can be provided by stop losses, price levels that mark automatic exit from the trade, aimed at limiting losses. The difficult part is figuring out how much you are willing to lose, and calculating the price level corresponding to that loss. Among other things, setting a stop loss is always a good and right thing, regardless of the use of leverage.