Extreme market volatility and leverage: A double edged sword
What is extreme market volatility?
Whilst market volatility can simply be defined as sharp and unpredictable change of price, it is much more than that. These peaks and troughs may appear meaningless; however, sense can be made from them. Repetitions and trends often develop and predictions can formulate. When it comes to trading in the foreign exchange market, being able to navigate through extreme volatility is a fundamental skill as it can determine success or failure. Additionally, levels of volatility provide indicators about the currencies. Those with more extreme volatility are considered to have more risked involved, as the values can be unpredictable. But with that comes the ability to reap greater rewards.
What is leverage?
Leverage is the ratio of a one’s funds to the figure of the borrowed funds provided by a broker for trading. You may have heard of 100:1 or 200:1 leverage. These are common ratios amongst forex brokers. Keep in mind each broker is different and will offer different leverage amounts. The amount that the account holder has available to them is multiplied by the larger number specified by the broker. This amount of borrowed resources aims to enhance the value of a trader’s trade.
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Both ends of the sword
Extreme market volatility is commonly viewed as a negative. This is because with it comes high levels of uncertainty and risk. Particularly for those who are short term speculators, it is important to stay away from highly volatile currencies as there is always the possibility of a sudden, sharp loss. In saying that, volatility is also one of the most attractive attributes of forex trading. For those who are willing to take the risk, in a calculated manner, have the ability to seek profits much greater than that of their actual initial deposit.
Similarly, when it comes to leverage, the sword is sharp at both ends. For many, it can be a highly beneficial tactic. In simple terms, if you to purchase a currency at $2 and you have $100 in your account you will have $200 worth of that currency. If that currency increases by 10 cents your profit would be fairly minimal at $10. However, if you are able to leverage your initial $100 at 1:100, you will now have $20, 000 of the currency, meaning a 10 cent increase will provide you with $1 000 of profit all from the original $100. Forex traders use leverage to profit from relatively small price changes in currency. It is a great tool to increase profits. However, like volatility, it can also lead to a steeper enlargement of losses when your holdings decrease. This table below assesses the proportion of traders who lose money with each of the major Forex & CFDs brokers.
As can be seen above, more often than not traders lose money so it’s important not to bite off more than you can chew when it comes to leverage.
Pairing the two
Using a lot of leverage at a time of extreme market volatility, like we’re seeing now, is very much like playing with fire. When carried out in a careful and highly calculated fashion, by those with experience in this area, amplified profits will often ensue. Yet, not taking adequate steps to seriously mitigate risk can result in serious losses.