The danger of trading with a large leverage

Leverage

Leverage is somehow considered a financial tool that allows the traders to get more exposure to the market than the actual capital deposited to execute the trade. Leverage can magnify potential profit as well as a potential loss.

How Is Leverage Used？

Leveraged trading is credit trading by keeping a small amount of money and getting a more significant amount. For example, a transaction in the EUR currency market has a contract value of USD 125,000. The trader can make the same trade with approximately $6,000 in cash with the use of leverage. Leverage is used in terms of margin. This is the minimum quantity of money that traders must need to trade with leverage. So, $6,000 is the margin requirement, and the remaining $119,000 is the leveraged amount.

The danger of leverage.

A common mistake made by Forex traders is to use leverage without considering the risk associated with the amount of money available on their trading accounts. Leverage can wipe out a trading account very quickly if it is not appropriately managed.

For example, if a trader has a $1000 trading account and uses 100: 1 leverage, with every one pip, the cost will be $10. If the stop loss is managed at ten pips from the entry point and is hit, the trader will lose only $100 or 10% of the price. Generally, reasonable traders will not risk more than 3% of their account and follow strict money management rules.

How does high leverage impact your trades？

Traders that operate with high operational and financial leverage can be an unsafe venture. High operating leverage indicates that the trader is making few sales but with high margins. This can present a high risk if the trader fails to forecast future sales. If the estimated future sales are marginally higher than the actual, it can create a significant difference between actual and budgeted cash flows. This will have a significant impact on the trader’s future operating capabilities.

A high leverage ratio usually indicates that the trader has been aggressively financing his growth in debt. This can bring volatile returns due to additional interest costs. If the interest costs rise too high, it can increase the risk of default or bankruptcy.

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