The statement that ‘leverage is a double-edged sword’ is well known; despite it is basically useful, it can also be harmful if ignoring the required considerations. Leverage is indeed an approach to trade with other people’s money. It seems to be wonderful, but on the other hand, it is based on a severe guarantee, i.e. the trader's deposit.
Trick or Real
Some people think that leverage is just a trick (and probably not legitimate), as it seems to be impossible to use other people’ money for trading (when they have no expectation from the trade profits). However, it is not unusual, it is similar to buying a home with a mortgage. This is an essential feature of the housing market, as most people do not have have enough money to buy a home without financial aid.
In the financial markets such as forex and stock, the required mortgage is provided via leverage. However, risk management is a required consideration for working with leverage.
Guarantee for Leverage
When a bank offers a mortgage or loan to a client, the first thing that comes into attention is the necessity of a suitable guarantee. In the housing mortgage, it is a routine manner, as the guarantee is the home itself. In the case of leverage, the guarantee is the deposited fund.
How Leverage Works?
A broker provides a higher credit for a trader based on his deposit. This allows the trader to open larger positions, and consequently more profit. In a typical case, a trader with $1000 initial deposit can trade $100,000 of a base currency in forex or equivalent shares in stocks, if his broker offers a leverage of 1:100.
For example, the trader can trade 1 lot ($100,000) of USD/JPY. The guarantee here is the $1000 initial deposit. This means that the trader can handle only $1000 loss in his open position. Upon opening a position of USD/JPY with a quote price of 100 (USD/JPY = 100), if the price falls to USD/JPY = 99, the position loss is $1000; thus, the broker closes the position to take the $100,000 loan offered ($99,000 value of 1 lot of USD/JPY + $1000 deposit of the trader).
If the price backs to USD/JPY = 101, the trader profit would be $1000, but nothing here as the broker has closed the position. If the trader was able to foresee this opposite oscillation, then he was able to make a 100% profit in a single trade.
Risk Management
As shown in the above example, leverage is something good in favor of the trader’s profit, if a trader can manage the risk issues properly. This is like the risk management for buying a home with mortgage, as one estimates the affordable monthly payment not to lose the home as a result of ‘not paid bill.'
There are two practical ways for risk management in working with leverage: using stop-loss in short-term trading systems, or considering a safe value for the possible opposite price movement.
Necessity of Leverage
Leverage is indeed a necessity for a junior trader with a small amount of fund for trading. In the above mentioned example, without a leverage the trader can only trade 0.01 lot of USD/JPY, and if the price moves to USD/JPY = 101, the trader’s profit is only $10. Thus, even by using a completely successful trading strategy, the trade profit is not worth of the time spent.
Trading with the Margin
The most useful aspect of leverage is the possibility for trading inside the available margin, and it is the way professional traders use leverage. Once again, in the example given, without leverage (or 1:1 leverage) the trader can handle the opposite price movement up to USD/JPY = 0. As this is almost impossible, a professional trader uses the available margin, which is unlikely to be used according to the price movement.
Thus, a trader uses a leverage of e.g. 1:5, as he can handle the price movement to USD/JPY = 80 (i.e. a safe range). Practically, leverages higher than 1:20 cannot be used effectively by a trader due to the severe oscillations of the price. Thus, the propagating leverages (like 1:500) are just an advertising trick utilized by online brokers.
References and Further Readings
James Chen, Essentials of Foreign Exchange Trading, Wiley, 2009.
John Bland, Jay M. Meisler, Michael D. Archer, Forex Essentials in 15 Trades: The Global-View.com Guide to Successful Currency Trading, Wiley, 2009.
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