Opportunities and risks under the double-edged sword: Leverage effect in trading

People who do foreign exchange trading will inevitably need to consider the leverage of the transaction. In this market, leverage, as a key financial tool, not only provides investors with opportunities to amplify returns, but also brings higher risks. Today, EagleTrader wants to explore this indispensable element with traders in depth – leverage, and learn about its core role and importance in forex trading!

     The basic principles of leverage effect

Leveraged trading is also called margin trading, which allows you to trade on positions with larger funds than you can use. Leverage in trading refers to the use of borrowed funds to increase the potential return on investment. It enables traders to open positions more than the amount of capital in their accounts.

The leverage ratio is usually set by brokers, and the common ones are 1:100, 1:200, 1:400, etc. This means that investors can control up to 100, 200 or 400 units of trading funds by investing only 1 unit of capital.

For example: If a trader has 1,000 yuan in his account and uses 10 times leverage, he can open a position worth 10,000 yuan. Brokers will lend traders an additional $9,000 to expand their position.

The advantages of leverage effect

• Amplify the investment scale: Leverage allows investors to control larger transaction scale with smaller funds, thereby improving capital utilization. This is especially important for small investors, as they can access the otherwise difficult-to-reach foreign exchange market through leverage.

• Increase potential returns: Due to the amplification effect of funds, investors can obtain higher returns when the trading direction is correct. For example, if investors use 100:1 leverage, when the market exchange rate changes by 1%, their real rate of return will reach 100%.

• Reduce transaction costs: Using leverage can reduce the cost of funds per transaction because investors do not need to pay the transaction amount in full. This helps investors trade more frequently to capture market opportunities.

Risks of Leverage Effect

However, the leverage effect is also a double-edged sword. While amplifying returns, it also amplifies potential risks.

• Increase the risk of loss: If the trading direction is incorrect, the investor’s losses will also be amplified. In extreme cases, if the market trend is contrary to expectations, investors may face huge losses, even exceeding the initial investment principal, resulting in a “slide”.

• Margin recovery risk: When the account value is below the minimum level specified by the broker, investors need to add additional funds to maintain their position. If margin is not added in time, the broker may forcefully close the position, causing the investor to lose some or all of its funds.

• Impact of market volatility: Due to the existence of leverage, small fluctuations in the market may also have a significant impact on investors’ profits and losses. This requires investors to have stronger market analysis and risk control capabilities.

How to use leverage reasonably

1. Understand the leverage effect: Investors should fully understand the role and potential risks of leverage before trading. Only by clarifying your risk tolerance and investment strategy can you make wise decisions.

2. Choose the right leverage ratio: Different investors have different ability to withstand risks, so they should choose the leverage ratio that suits them. For the firstScholars suggest using a lower leverage ratio to reduce risk.