20.Why use leverage?
The purpose of leverage
The use of leverage is derived from margin trading. It comes from the fact that both the buyer and the seller deposit “margin” as a guarantee to fulfill the contract in the future. Since margin is mostly calculated as a proportion of the contract size amount, that proportion is the “leverage concept”.
In financial markets, many brokers will offer margin trading services, such as mortgage lending and derivatives which usually involve leverage. The purpose of leverage is to make lower entry barriers for smaller investors to access the market. However, this mindset is not always true. The leverage arrangement is essentially used on some financial assets with little volatility but with a large number of transactions.
Leverage is often used in forex trading because the daily fluctuation of the forex market is quite low. In most situations, the fluctuation of major currencies is less than 1%. That is why investors, brokers, and banks believe that those transactions do not need to be paid in full, and the settlement of the contract can be ensured through a margin.
It is not difficult to find that specific assets, unpopular stocks or currencies, are seldom traded with leverage involved. When the markets turn out to be risky, banks and brokers will lower their leverage ratios to ensure the settlement of contracts are delivered orderly.
Pros and cons of margin trading
In short, leverage trading comes with both the good and the bad. By using leverage, investors can make their capital work much more efficiently, with more flexibility compared to those without using leverage, making better use of their capital to seize more opportunities or by increasing their investment exposure to magnify profits in favorable market conditions.
However, when the profit is amplified, the loss can also be amplified when the market goes bad. Some investors may have mismanaged their positions, resulting in insufficient margin and they may receive margin calls. Besides, investors may be forced to close their positions at extremely bad prices when the market fluctuates dramatically, like in “market crash” situations. It is also important to note that leverage involves lending arrangements of brokers, and usually implies financing costs in the transactions.
Next Articles: 21. What is overnight interest?
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Risk Warning: The above content is for reference only and does not represent ZFX’s position. ZFX does not assume any form of loss caused by any trading operations conducted by this article. Please be firm in your thinking and do the corresponding risk control.