Trading and investment activities are always associated with certain risks. The situation on the market is influenced by a lot of various factors, which can be difficult to foresee. To minimize the chance of loss, you should know how all the tools work and clearly understand the consequences of using them. In this article, you will learn all about leverage risk management. On the one hand, borrowed funds open up more opportunities for you to profit; on the other hand, they increase the size of potential losses.
Contents
What Is Leverage
Leverage is a convenient trading tool for platforms, like MetaTrader 5 download, that represents the ratio of your capital to borrowed funds. With it, you can increase your own profit from transactions even without having enough money. The amount borrowed generally depends on how much you have in your account, as well as the brokers’ conditions. They can be minimal, like 1:10, or quite “aggressive,” like 1:1000.
To help you understand how leverage works, here is a simple example. If you have $500 and want to buy shares worth $100 each, you can only buy five. However, when using a 1 to 100 leverage, you have the opportunity to purchase 100 times more. If the share price rises by $1, you will make a profit of $500. If it falls by $1, you will lose your entire deposit.
Assets may have different risk rates. It takes into account the potential price change and also affects the amount of leverage. The lower this figure, the more money you can borrow. Keep in mind that the risk rate is reviewed every day. To always be aware of the potential outcome, you should use calculation tools like the Forex trading calculator. The general mechanism of leverage is designed in such a way that you cannot lose more than you have. However, in an unsuccessful scenario, you can literally lose everything.
Pros and Cons of Leverage
This tool is a tempting option for those traders who do not have a lot of capital to get started. In general, it has several significant advantages:
- opens access to large assets;
- allows you to make a bigger profit;
- allows you to place orders significantly higher than your financial capabilities.
However, you cannot focus solely on the positives. Leverage also carries real risks, especially for those who have not studied how it works well enough:
- the amount of your income from using this instrument is the same as the sum of potential losses;
- novice traders tend to perceive such funds as their own, which is why they do not have money management skills;
- large leverage increases transaction costs.
When choosing trading instruments, you should carefully weigh the pros and cons and soberly assess the possible consequences for your finances.
Leverage Risk Management for Traders
There is an opinion that risk management and leverage are incompatible concepts since using leverage is a rather risky activity in itself. However, experienced specialists have certain techniques and advice for novice traders on reducing (not completely eliminating) potential risks. Here are a few of the main ones.
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Take small loans
If you are a beginner and cannot predict the most likely outcome of a particular transaction, do not take large loans. In this case, it is better to use smaller leverage, for example, 1:20 or 1:50. It will give you the opportunity to make a profit without having a large amount of money, but at the same time protect against large losses. So you simply cannot lose everything at once. Besides, in this way, you still have to learn how to manage your capital without relying on outside help properly.
Set Stop Loss
An order to your broker to sell a stock if its value falls to a certain level is called Stop Loss. In simple terms, it serves as an automatic limiter for your losses. You determine in advance what amounts you are ready to lose in case of a negative development of events. Trading without Stop Loss is an extremely risky approach. You do not always have the opportunity to monitor price changes continuously, or some force majeure may happen, such as a power outage. Also, this tool can help you if you misjudge the situation, which is especially important when using leverage.
Opt for a smaller risk per trade
Leverage creates a dangerous illusion that the borrowed money is yours. It leads to the fact that traders begin to enter into too large transactions, counting on higher profits from them. But you should never forget that stocks can both rise in price and fall. Accordingly, the risk of financial losses always remains.
Experts do not recommend raising the risk per trade above 2%. While a 20% risk can bring you a lot of profit, it can also take a lot of money from you. The main purpose of this approach is to help you keep the bulk of your capital even if you have several unsuccessful trades in a row. It will be easier for you to recover from such losses and get back into the game because the likelihood that you will lose, say, 50 times in a row is incredibly small.
Use trading calculator
To find out how profitable this or that investment will be in the current market situation, you should make calculations in a digital trading calculator. In it, you can choose a trading instrument, specify the size of your leverage, pick currency, lot size, and so on. Based on the received data, you can decide on your further actions. Estimates can be done manually, but such a process is time-consuming and may be associated with critical errors. Ready-made calculators on the broker’s websites reduce the probability of mistakes to almost zero and allow you to calculate several orders at once.
Use Leverage Advantages to Your Benefit
Leverage is a very tempting tool, but it can be especially dangerous for inexperienced traders. Remember that only you are responsible for your decisions and, therefore, for losses. Although trading is always associated with risks and financial costs, if you lose your money too quickly, it is an indication that you need to rethink your strategy and learn how to manage money.
Please share your experience with leverage. Do you use it in your trading strategy? What advice would you give to newbies regarding it?