A financial market is a very complex and diverse field that needs specific knowledge and skills in order to make the process beneficial. There are many technical characteristics and a thorough understanding of those tools might result in an efficient trading process. One of those tools is leverage, which is also quite controversial. There are many different opinions around the use of leverage, and to start with, the main idea of its use is that it gives the people the opportunity to trade with a large number of contracts and shares with a small amount of money.
After hearing this, some of you might think that this is a great opportunity, while a lot of people will think that something will not be as easy as it sounds. However, in the majority of cases, the beginners on the market are advised not to start with the high leverage especially on the markets such as markets of options and warrants. And in return, advanced traders on the market will respond to this argument by the fact that not all markets are so vulnerable towards leverage and that in many cases, it is utterly beneficial.
Leverage and risk factors
To describe the whole leverage mechanism and put them into simple words, it is considered to be the risk factor due to the fact that it increases the possibilities for the profits as well as it can make the losses magnified as well.
The specific example will make it more clear. For example, if the trader is trying to start with the amount of 1000 USD and if the brokerage company is advising the leverage of 1:100, the potential profits will be 100,000 as well as the potential loss. In the perfect scenario, it is better when the traders are having the possibility of losing the same amount that they started with. No doubt that the risk of losing 100 000 is too notable, even when you are starting with the thousands of dollars, but the winning prize should also be taken into account.
One of the important aspects that should be taken into consideration in this regard is the brokerage company itself and its performance on the market. The best way for checking the performance and the capabilities of the company is to search for a review that contains detailed information about the whole characteristics and tools. For example, XM Forex broker review shows that the company has various payment methods as well as advanced software, which increases the general assumption about the company, however, in terms of leverage capabilities, the potential client should make the measurement of the company’s financial leverage.
Leverage – explained
Financial leverage, trading on equity or simply, just leverage, is when the traders are trading with the borrowed money and start trading with that. The debt amount and the leverage size are in direct proportion with each other. When the leverage number goes up, it is vivid that paying the debt in case of failure is becoming more and more difficult. This is not the same as making a loan to buy a car, because the bank gives you the amount of loan that they have calculated you will be able to repay. However, in the case of leverage, you are borrowing money to buy a financial asset that you expect to grow into the price and will be able to pay for itself.
However, on the other hand, the leverage also gives the traders the opportunity to make the best out of the current situation. Surprisingly or not, using leverage can also be used as an opportunity to reduce some risks. For example, if the trader is ready to purchase 10 000 shares of an individual stock, which price is $5 per, the required trading capital in this current case is $50 000 which is quite a big risk. What leverage does, in this case, is that it gives the opportunity to earn the same potential profit, with risking only $2500 roughly to say.
Measuring Financial Leverage
This is not easy for the brokerage company itself. The managers, shareholders, and lenders need to thoroughly analyze the risks that the company is carrying, which means that they should know everything about how much the company is financially leveraged.
The financial leverage of one certain company can simply be measured by using the debt-to-equity ratio. This simple formula shows the likelihood of the company when the company was able to meet the debt obligations. It also shows the capabilities, whether the company can take the debt to grow or not.
How leverage works
The main reason why the companies are offering leverage to the clients is to obtain as many financial projects as possible. In this case, the main aim is to earn the most out of the opportunities from asset trading. The cost through debt would be way higher than in the case of using leverage.
Due to the fact that the process is not simple, there are two major factors that need to be taken into account. The first one being the fact that the asset will earn enough to make the payments on the debt, and the second being the fact that the volume of the asset will not fall.
For example, the company is making the decision of buying another company and taking a loan for that, only because it believes that the profits that will be earned after the purchase will overlap the amount of the loan. Or in the case of starting up a new project, there should be faith that the spending will not exceed the amount of profit.
However, there always is a risk of something going wrong since it is impossible to calculate the exact outcome. In this case, the company will be left with worthless assets. Deciding on the usage of financial leverage and whether or not it is worth it, is a very difficult decision to make.
The possibility of earning a lot of money sounds too good, however, if something goes wrong, the brokerage company will contact you to put a margin on the current account to cover the losses. Other than that, it is a common practice when the brokerage companies require you to keep a specific amount of money on your brokerage account, in order to pay the margin calls, in the case of something not going according to the plan.
Interesting Related Article: “Introduction to Forex Trading: Leverage“