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Financial leverage

Vojtech Pavek
22/12/2022

In this article, we will talk about what financial leverage is, how it is used and what the advantages and disadvantages are.

Financial leverage is a method of investing in the world of finance, in which the investor uses their own capital, but also foreign (borrowed) capital to purchase assets.

Leverage is a strategy in which an investor uses debt (borrowed money) to invest in certain financial products, thereby increasing the potential return on the investment. This allows the trader to open a larger size possition with a smaller amount of invested capital using a temporary loan.

Using leverage requires a certain amount of margin that is needed to open a trade. However, the margin is not a cost and will be returned to you after closing the deal.

On the one hand, leverage can be very helpful because you need less funds to make significant profits. However, on the other hand, the use of financial leverage can be very risky, because you can go into a significant loss. This is one of the reasons why risk and money management is one of the key factors in achieving success in the market.

That is why it is important to set a maximum loss limit (stop loss) for each trade and to follow other rules of money management when trading.

Let’s take an example:

An investor buying shares is leveraged 1:2. This means that half of the money is his own, the other half is borrowed by the broker. If the share price falls by 5%, the investor loses 10% of his invested money.

The volume of borrowed capital is usually several times larger than own funds, the ratio varies from 1:2 to 1:several hundred. When trading currencies, it is most often 1:100 or 1:200. For shares and commodities, it is usually lower, e.g. 1:10.

The aim of this operation is to increase the profitability of equity capital.

That is why it is important to follow the basic rule of money management even when trading on leverage, namely that you risk a maximum of 1-2% of your capital per trade.

Unlike other markets, leverage is quite common in the world of Forex. Brokers often “get ahead of themselves” in the amount of leverage provided. Numbers 1:1000 or 1:2000 are no exception.