Leverage is a critical concept to understand and should be part of any money management system. Leveraging Forex trading platforms in South Africa are not different than any other trading platforms in different parts of the world, so some generalities about leverage are useful to every trader.
What Is Leverage?
Above all, leverage is a measure of risk. The higher the leverage used, the higher the risk.
Sure enough, like in portfolio management theory, higher returns are impossible without higher risk. But higher leverage works both ways. While it enables higher returns, it also increases the risk exponentially.
For every position opened in the market, the broker blocks a collateral, also called margin. The leverage and the margin post as collateral are inversely related.
The higher the leverage, the lower the margin required to post for a trade. Also, the lower the leverage, the higher the margin.
In other words, for any given position, the trader comes up only with the amount to cover the margin, while the broker comes up with the amount needed for the leverage.
How Does Leverage Work?
An account with high leverage increases the risk because plenty of margin will be left to trade. Vice versa, an account with low leverage requires more margin for each trade. Hence, the trader will be limited in the number of open positions to have in the market at any one time.
One may think at a trading account as having four elements – the balance, the equity, the margin, and the free margin.
The balance shows the funds deposited for trading. It declines or rises with every closed trade with a loss or a win.
Equity is more sensible to changes in the trading account. Equity reflects the trading account’s value at any one point, considering the open positions too.
From the equity, the margin is deducted. That is, the margin required as collateral for the open trades.
Finally, the free margin level is the margin left for use as collateral for any new position, and it equals the difference between the equity and margin levels.
Low Leverage Reduces Overtrading
We can all agree that leverage works in both ways, amplifying a trading account’s upside and downside. Hence, controlling leverage means controlling risk.
Overtrading refers to the process when a trader opens more positions than initially intended for the simple reason that plenty of margin is still available to trade. As mentioned earlier, margin is inversely related to leverage.
Hence, the higher the leverage, the lower the margin needed as collateral, and the higher the margin available for new trades. Because of that, traders feel that it is safe to open new trades as margin is available, which leads to overtrading.
Studies have shown that overtrading is one of the main reasons why traders fail in the FX market.
