Leverage involves the use of financial instruments like margins and borrowed capital to increase an in investors returns. This is a common means that investors use to finance their trades.
Leverage and how it works
Since not all traders can finance themselves comfortably, they approach brokers in order to obtain leverage. Brokers can provide leverage worth ninety-nine percent of the total trade, though they do not charge interests unless necessary. A client simply needs to provide one percent and then utilize the ninety-nine percent provided by the broker. Charging of interests is only applicable to investors who fail to close deals or trades at the agreed time. The amount charged as interests fully depends on the rates at which the currencies are trading. If the exchange rates are high, the interest rates automatically rocket but if they are low, the investors may not feel the impact the interests have on their investments.
Investors may as well obtain leverage from futures, margins and options and not necessarily from brokers. For instance, if an investor has a thousand units of currency to invest, they may divide the investments into ten smaller investments. To boost leverage, the investors could reduce the ten investments to five such that they can control about five hundred shares. This is a decision that investors can make to increase leverage and they do not have to consult with any broker or trader. Companies investing in the forex market prefer to use their debts so that they can finance their operations. This is a suitable option for companies that have debts because it enables them to trade without increasing their equities.
For instance, investors may contribute to the formation of a company by contributing five million units of currency. This means that the company’s equity is worth the five million units of currency. The company operates by use of the equity contributed by the investors but incase they obtain a twenty million debt financing; the company will have twenty-five million at its disposal for investments. This venture increases the value of the company’s shareholders. This explains the main objective of obtaining leverage from brokers or by other means. Leverage enables investors and other companies to operate or make investments comfortably. However, individual investors or companies that invest using leverage normally do so at a very high risk.
If they lose a trade, the loss becomes greater as opposed to if they had invested without leverage. This also explains why many brokers charge their clients interests in the event that they make heavy losses. Most people obtain leverage assuming that it will only increase their chances of making wins. This is not the case as leverage magnifies losses and gains equivalently. Companies that use leverage to increase shareholder value could experience a loss thus causing a decrease in their value. They may also have to pay interests to the brokers, who would not want to incur losses after making heavy investments. This could be quite disastrous especially if the company has very little capital in their accounts.