Leverage ratios are the best indicators for businesses and banks as they tell how their assets are financed, whether through debt or equity. In addition to this, they are also a useful tool for traders and investors because leverage ratios tell them how they can fulfill financial obligations easily. But what a leverage ratio, actually is? Here’s everything you need to know about it.
Understanding Leverage Ratio:
In simple words, leverage ratio means the proportion of debt as compared with equity or capital. Banks and other financial institutions often use leverage ratios to monitor their finances. However, businesses can also make use of a leverage ratio for their own benefit. For a company, a leverage ratio represents the debt amount in comparison to different accounts like a balance sheet, income statement or cash flow statement.
Meaning Of Leverage And How It Is Created?
Many companies depend upon a combination of debt and equity to finance their operations. Leverage is created keeping such scenarios in mind; however, the end objective is always financing. A few examples of it are asset-backed lending, cash flow loans, leveraged buyouts, equity investing and financial instruments.
Leverage In Forex Trading:
Leverage in forex trading is similar to a “loan” that the broker offers to the traders. Using leverage, traders can have more capital to trade with than what they initially deposited. Leverage is represented in the form of a ratio. A typical forex broker’s common leverage levels are 1:50, 1:100, 1:500 and so on. However, the leverage level can vary from broker to broker and depend upon the traders’ knowledge and expertise and online evolve markets review and rating.
How To Calculate Forex Leverage?
Let’s understand this with the help of an example. Say a trader has an initial trading capital worth $10,000 and uses a leverage of 1:100. Thus, according to his leverage ratio, he can trade with capital which is 100 times more than his initial capital, meaning he now has $1,000,000 (10,000*100) to trade with. If he decides to purchase the forex pair USD/EUR, with a current exchange rate of 1.3255 and closes his trading position at 1.3355, his capital will almost double the actual capital ((1.3355 – 1.33255)* $1,000,000 = €10,000).
Similarly, if the same trader buys USD/EUR at 1.3075 and closes his trading position at 1.3025, he loses his capital almost by half. ((1.3025-1.3075) * $1,000,000= – €5,000. Therefore, it’s worth mentioning that leverage has the potential to multiply your capital and offer you opportunities to increase your profits; but at the same time, it can magnify your losses too. Thus, it is recommended that traders (especially beginners) use leverage wisely.
How Much Leverage Is Right For You?
In the forex market, you can access leverage as high as 1:2000. But just so it is available does not mean you need to use it. For a conservative risk-taker or someone who is new to forex trading, low leverage is the best option. 1:5 or 1:10 might work best for such traders. If you’re in the market for an online broker, read kucoin review to help determine which brokerage account is for you.
One can choose the right leverage based on the following factors:
- Risk appetite- a risk taker would not mind putting all his capital at stake, but how much are you willing to lose?
- Risk management strategies- do you have a risk management strategy such as stop-loss?
- Experience in forex trading- low forex leverage is preferable for a beginner.
Can I Trade Without Leverage?
Yes, indeed, it is your personal choice whether or not to use leverage while trading forex. Some traders only prefer to use money available in their trading account for trading, but their potential gains are much lower as compared to those traders who use leverage. Forex trading without leverage can benefit traders in the following situations:
- Traders with large trading account balances; of more than $100,000.
- Traders who just want a steady return on their investments without risking too much.
- Traders who do not aim to make a living with forex.
- Traders who are just out there to get a gist of the forex market and want to expand their market experience by practicing numerous strategies with real money- but do not want to risk their entire deposit.
Some Tips That You Can Follow When Trading With Leverage:
- Try to use low leverage if you are a forex beginner.
- Never try to get out of a losing position by investing more- “cut your losses!
- Use stop-loss and other risk management strategies to protect your capital.
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