The risks of leveraging when it comes to investing
Leverage can be both friend and foe to investors. But there are ways to tame the downsides.
In simple terms, leverage means borrowing to invest. And it's something plenty of Australians do on a daily basis.
When you buy a home using a mortgage, you may only stump up 5% of the purchase price. The bank lends you the rest. But when you sell up, you're entitled to pocket 100% of the capital gains. Even if your home triples in value, you only have to pay out the amount remaining on your loan - the lender isn't entitled to 95% of the capital growth even though they lent 95% of the value of the property.
It's this potential to earn a lot of money from a small contribution of your own cash that makes leverage so appealing to investors. But leverage doesn't just apply to property markets. It can also be used to invest in a variety of other assets. Shares for example, can be leveraged through margin loans.
However, there are few markets where leverage is more amplified than foreign currency (FX) trading.
Small daily movements require leverage
On one hand, it doesn't take a lot of cash to start trading FX. With some platforms you can get started with less than $AUD500. The problem is that currencies tend to move by just a few cents, pence or pesos, each day. You'd need to invest massive sums of cash for those small movements to translate into decent gains. Enter leverage.
The highly leveraged nature of FX trades mean that you can take out a high value trade for just a small down payment. A $25 trade for example may be leveraged at a ratio of 100:1. In practical terms this means you have exposure to $2500 worth of market movement.
An FX trader who is leveraged at, say, 200:1, may invest $1000 of their own money to take a $200,000 position on a currency. This means $199,000 is borrowed from the FX broker (or trading platform). If the currency drops by just 1%, the trader can lose $2000, comprised of $1000 of personal money plus $1000 borrowed from the broker. In this way it's easy to see how leverage can leave the FX trader owing money to the platform. Put simply, you can lose more than your initial investment.
The key takeout for investors is that leverage can work both for and against you. It can magnify gains. But it can also ramp up any losses. What matters is the way you manage that risk
Leverage can be managed
For FX traders, a range of online tools is available to lower - though not eliminate, the downside risks.
Daniel Byrne, Asia Pacific managing director of FX platform easyMarkets, says, "Most people take out insurance for the peace of mind over the things they truly value. Savvy traders apply that same logic to their risk capital."
He explains, "Trading with leverage involved doesn't have to be an 'all in, one way bet'. Downside risk can be managed by placing hedging positions through the use of options, CFDs or other instruments."
Even with these tools available, it pays to start out trading FX in small sums using a low level of leverage. Give yourself time to get a feel for the impact of leverage. You can always raise the stakes as you gain experience.
Demo accounts, which are a feature of most trading platforms, are a great way to grasp the impact of leverage in a real world setting. You can make dummy trades using live data and real trading tools without putting hard cash on the table. Sure, there is nothing quite like the real thing to sharpen your skills, but if you are starting out in FX, demo accounts are a practical learning tool.
Get stories like this in our newsletters.