In some fields of business, such as real estate, you'll frequently hear that the way to make money is by "using other people's money". This is true in the case of every real estate transaction that involves a mortgage; when you use a mortgage to buy a house, you are using other people's money, in this case, the bank's. The concept of using other people's money to enter a transaction can also be applied to the financial markets through a tool known as leverage. In this article, we'll explore the benefits of using borrowed capital for trading and will examine the common misconceptions about this tool's excessive risk. (For background reading on leverage in forex, see our Forex Beginner Guide.)

Leverage in Other Markets

Borrowing money from a bank is the most common method that allows the average person to buy a bigger house than he or she could otherwise expect for the amount of money readily available. When this concept is applied to commercial properties, it provides a greater return on equity than if the buyer had paid for the entire property using only his or her own funds.

For example, suppose that you own a leased property that you bought for $1 million and the property returns a net 15% each year; your return on investment is 15% per year. However, suppose that instead of paying $1 million in cash, you mortgage the property and borrow $800,000, and therefore only invest $200,000 of your own money. After paying the interest on the loan, you may only achieve an 8% return, rather than 15%. However, 8%, or $80,000, divided by your equity investment of $200,000 is actually equivalent to a 40% return on your investment. In real estate, this type of leverage is considered perfectly acceptable and is actually encouraged.

Risk From a Different Perspective
Now when it comes to the markets, especially the forex markets, the pundits tend to look at leverage as a dirty word. Many go as far as to suggest that it's a strategy that we should be afraid of, and resisted at all costs. They tell us that leveraging in the markets is a double-edged sword that will cut both ways. If we make a profit on leveraged investments, the returns can be huge; if we make losses, those losses can devastate an account. Of course, there is truth to this statement, but the double-edged sword analogy can give an incomplete account of how forex actually works. (For more on this view, see Forex Leverage: A Double-Edged Sword.)

If you understand how leverage works and learn to handle it correctly, you can use its power to build wealth. Returning to the sword analogy, the way to do this is to use the blade to cut out losses quickly, leaving the profits room to grow.

Similarly, some people liken trading with leverage to a journey in a car. You could walk to your destination, but driving is a much more efficient solution, especially if the destination is far away. Driving a car is probably much riskier than walking, and statistically more people die in road accidents. But how many people listen to those statistics and never drive in a car? Investors' fear of leverage is often similarly absurd.

Leverage In the Forex Market
In the foreign exchange markets, leverage is commonly as high as 100:1. This means that for every $1,000 in your account, you can trade up to $100,000 in value. Many traders believe that the reason that forex market makers are prepared to offer such high leverage is because leverage is a function of risk. They know that if the account is properly managed, the risk will also be very manageable. Otherwise they would not offer the leverage, simple as that. Also, because the spot cash forex markets are so large and liquid, the ability to enter and exit a trade at the desired level is much easier than in other less liquid markets. (For more on getting in and out of trades, read Place Forex Orders Properly.)

Let us look at an example of a leveraged position in the forex market and how such a position should be managed. Assume, for this example, that you are interested in trading the U.S. dollar against the Canadian dollar (USD/CAD). Let us also suppose that you have $10,000 of trading capital in your account. One of the first rules in trading your account is to define a risk profile. For example, you may decide to never risk more than 2% of your trading capital in any one trade. This means that you will not be prepared to lose more than $200 in any trade as long as your available capital remains at $10,000. As you can imagine, the 2% rule means that you have a good chance of staying in the game. The odds are stacked against a string of losses, but, by sticking to the 2% rule, a leveraged account can still be reasonably safe. (For more on this strategy, check out Limiting Losses.)

Factors To Consider
There is more to managing leverage than just setting up a 2% rule - you also have to take the personality of the market into account.

For example, suppose the USD/CAD had a daily range of 70 pips. If each pip is worth approximately $10, then you can only risk 20 pips in order to stick to the 2% rule. (2% of $10,000 = $200 and if 1 pip = $10 then $200 = 20 pips.) Therefore, when you enter into a trade, it is important to place a stop loss no farther away than 20 pips. If the stop of 20 pips is in such a place that the normal back and forth movement of the market is likely to hit the stop, you will be stopped out every time, and will incur a string of losses. As such, it is crucial that your stop be placed in a position that it is unlikely to be hit. If you are trading on a daily chart and that position is farther away than 20 pips, you might have to trade in a shorter time frame where the natural stop is not farther than 20 pips.

So, once you have determined the maximum amount of loss you can sustain, which is a percentage of your trading capital, (the 2% rule), and you understand the best place to position a stop loss so that the 2% rule is automatically enforced, but is unlikely to be hit, then you can use leverage to build profits quickly and efficiently. Whenever you think of leverage, you must think of risk management tools such as the stop order as the safety mechanism that controls its power.

There's no need to be afraid of leverage once you have learned how to manage it. The only time leverage should never be used is if you take hands-off approach to your trades. Otherwise, leverage can be used successfully and profitably with proper management. Like any sharp instrument, leverage must be handled carefully - once you learn to do this, you have no reason to worry.

Related Articles
  1. Stock Analysis

    Analyzing Altria's Return on Equity (ROE) (MO)

    Learn about Altria Group's return on equity (ROE) and analyze net profit margin, asset turnover and financial leverage to determine what is causing its high ROE.
  2. Stock Analysis

    Analyzing Boeing’s Return on Equity (ROE) (BA)

    Learn about Boeing's return on equity and find out how the company's ROE compares to its own historical performance and aerospace industry peers.
  3. Economics

    Understanding the History of Money

    Money has been a part of human history for at least 3,000 years, evolving from bartering to banknotes.
  4. Forex Fundamentals

    How To Calculate An Exchange Rate

    An exchange rate is how much it costs to exchange one currency for another.
  5. Stock Analysis

    Analyzing Verizon's Return on Equity (ROE) (VZ)

    Learn about Verizon's return on equity and find out how ROE is influenced by net profit margin, asset turnover ratio and financial leverage.
  6. Wealth Management

    How to Invest Like a Millionaire in 2016

    Discover how to start 2016 strong by learning how to imitate the investing strategies that distinguish millionaire investors from most average investors.
  7. Stock Analysis

    Analyzing AT&T's Return on Equity (ROE) (T)

    Learn about AT&T's return on equity. Find out how its recent ROE compares to historical results and those of peers in the telecommunications industry.
  8. Stock Analysis

    Analyzing Oracle's Return on Equity (ROE) (ORCL)

    Learn about Oracle's ROE. How have net profit margin, asset turnover and financial leverage influenced ROE relative to peers and historical performance?
  9. Forex Education

    Four Currencies Under the Spotlight in 2016

    With currencies having become the “tail that wags the dog,” in terms of their impact on the global economy, these four currencies will be under the spotlight in 2016.
  10. Stock Analysis

    Analyzing Cisco's Return on Equity (ROE) (CSCO)

    Learn about Cisco's ROE and see how the company's most recent results compare to historical results and large-cap networking and communications equipment peers.
  1. Can mutual funds use leverage?

    Traditionally, mutual funds have not been considered leveraged financial products. However, a number of new products have ... Read Full Answer >>
  2. How do hedge funds use leverage?

    Hedge funds use several forms of leverage to chase large returns. They purchase securities on margin, meaning they leverage ... Read Full Answer >>
  3. Do nonprofit organizations have working capital?

    Nonprofit organizations continuously face debate over how much money they bring in that is kept in reserve. These financial ... Read Full Answer >>
  4. How do hedge funds use equity options?

    With the growth in the size and number of hedge funds over the past decade, the interest in how these funds go about generating ... Read Full Answer >>
  5. What does a futures contract cost?

    The value of a futures contract is derived from the cash value of the underlying asset. While a futures contract may have ... Read Full Answer >>
  6. What are the goals of covered interest arbitrage?

    The goals of covered interest arbitrage include enabling investors to trade volatile currency pairs without risk as well ... Read Full Answer >>
Hot Definitions
  1. Presidential Election Cycle (Theory)

    A theory developed by Yale Hirsch that states that U.S. stock markets are weakest in the year following the election of a ...
  2. Super Bowl Indicator

    An indicator based on the belief that a Super Bowl win for a team from the old AFL (AFC division) foretells a decline in ...
  3. Flight To Quality

    The action of investors moving their capital away from riskier investments to the safest possible investment vehicles. This ...
  4. Discouraged Worker

    A person who is eligible for employment and is able to work, but is currently unemployed and has not attempted to find employment ...
  5. Ponzimonium

    After Bernard Madoff's $65 billion Ponzi scheme was revealed, many new (smaller-scale) Ponzi schemers became exposed. Ponzimonium ...
  6. Quarterly Earnings Report

    A quarterly filing made by public companies to report their performance. Included in earnings reports are items such as net ...
Trading Center