Anyone who is at least somehow connected with the foreign exchange market or trading must necessarily know what leverage ratio is. Today, we will tell you about the advantages and disadvantages of this financial measurement and for what purposes leverage interrelation is used.
Why do people resort to leverage ratio? With the help of it, a person may trade using more money than they actually owns. However, few traders manage to use leverage ratio profitably. Why does it happen? We will try to find it out, so go on reading!
The term "leverage ratio" interpretation
Leverage ratio — is a loan of money that a broker provides in the financial market for trading. The amount of cash may vary. For example, the capital in the form of debt (leverage interrelation) can be 1: 4 or 1: 500, and so on. If we see a 1: 100 loan indicator, it means the broker provides funds that are 100 times higher than yours, and you can trade using a hundred-fold sum.
To make the definition clearer, let's resort to the following example: brokerage firm offers the leverage ratio of up to 1: 1000. So, if a person`s current possessions are 10 dollars, then there is an opportunity to open transactions for up to 10,000 dollars. It is worth mentioning that the capital in the form of debt is not a loan in the usual sense of the word. The trader does not borrow any money from their broker, and, accordingly, should not return them a loan with interest. It is only an opportunity to trade with large amounts of goods or services.
However, it is important to mention that if a trader has struck a bargain (using capital in the form of debt) and it successfully works, they can enjoy with a higher income. But nobody must forget about the reverse side of the coin. If a trader has failed to guess the direction of the trend, the losses will be precise of the same correspondence.
Using a leverage interrelation, a trader does not risk becoming a debtor of a brokerage company, since the broker continually monitors the status of the transactions of his or her clients. The deal can be automatically closed if the amount of losses becomes equal to the quantum of the deposit. But, if a company is really interested in successful trading of its clients, then it will additionally ensure the trader by setting a stop out point — a critical level of losses when the transaction must be forcibly ceased.
The formula of the leverage ratio
READ ALSO: Development economics definition and purpose
The most used type of financial leverage ratio is the debt-to-equity ratio. It is calculated as follows:
D/E Ratio = Total Debt(Liabilities)/Total Equity
Let us try to transfer this formula on the following simple example:
- Step # 1. It is essential to determine the desired sum for a deal on the trading market. For example, let this amount be equal to $50,000.
- Step # 2. Let us suppose that a trader applies a standard ratio of 1:100 (while no one can say which coefficient is better – high or low, and there are too many opinions on this account). From the position of margin, it will mean the need to make a deposit equal to 1% of personal funds.
- Step # 3. It is necessary to calculate the amount of the required deposit from the ratio, which the broker will get on his account. So, following our example, 1% of the sum of $50,000 will be equal to $500.
Accordingly, the required level of deposit may be different. For those who do not want to mess with manual calculations, there is also a way out. Usually, every financial institution has a particular trader’s calculator with which you can carry out all calculations quickly and accurately. Among many others, you can use money-zine.com or calkoo.com.
The leverage ratio use analysis
Legit cannot give anyone a universal instruction of successful use of capital in the form of debt for your maximal profit, but we will show a simple example as long as theoretical explanations may look too confusing. Imagine that you have $100, which you plan to use trading on the currency market. At the same time, you plan to use the principles of the leverage interrelation.
The first thing one needs to do is choose a stock exchange. Start analyzing the size of the loan. Suppose you stopped at a broker who provides the maximum capital in the form of debt. Thus, one has an opportunity to take exchange funds in the relation of 1:1000.
Having taken the first step, one starts exploring the trading platform. You should understand the mechanism of trading on a particular platform. There is no risk of losing personal cash, as long as all brokerage companies offer an opportunity to practice on a demo account. So you can learn more about the service, and the use of leverage ratio.
Having passed the first two steps, one has already matured to make forecasts and decisions. Open an account and bet on the sale or purchase a particular currency pair. Then you can try to resort to the service from a broker. With a $100 on the demo account, one can easily use the sum up to 100×1000 = $100,000. Suppose, you consider it as a good option and do this. As a result, during the final step you will generate the income on the amount of the loan, but only in case if you make the right choice of the trend (remember that in the real world both variants – good and bad are possible). With a successful scenario of events, the amount of profit from your $100 would have been quite small, but as long as you used leverage interrelation, you had a chance to get more benefit.
Summing up, it is necessary to say that the leverage ratio is just a financial instrument that is designed to generate income. Unfortunately, it is not 100% effective tool, and it also leads to losses. However, if you decide to trade in the foreign exchange market, first of all, you must learn how to manage the capital, then the risks of losses will be minimal, and the use of capital in the form of debt will bring only profit! We wish you good luck!
READ ALSO: Why do we study economics?