What Is Leverage Trading? Basic Info for Novice Traders
Everyone who has ever encountered the world of trading and investing knows the concept of margin and leverage. They are interconnected and the main pillars of margin trading. Let’s take a closer look at what leverage trading is, what methods and strategies it has, and the advantages and disadvantages that are worth paying attention to.
What Is Leverage Trading?
Exchanges are wholesale markets for currencies, stocks, commodities, and other assets. Exchanges form the price of financial instruments.
For a long time, only rich people and large financial institutions could afford to trade on the global financial markets. The development of technology and the desire to attract more money from people with different incomes led to the emergence of additional opportunities. Leverage trading opened up the possibility to invest without large capital.
Leverage is the ratio of the required client’s funds to the funds needed to open a trading position. Leverage is provided by the brokerage company and allows the client to execute trades, the volume of which significantly exceeds the client’s own finances. Funds are not deposited to the client’s account but are used directly at the moment of opening a trade in accordance with the leverage set for the instrument or chosen by the client.
The leverage ratio reflects how much the trader’s own funds will be multiplied (1:100, 1:1000). For instance, the 1:500 ratio depicts that the broker lends the sum of 500 times more than the investor’s deposit.
In Forex, trades are measured in lots. The standard lot size is 100,000 units of currency, but there are also mini, micro, and nano lots of 10,000, 1,000, and 100 units, respectively.
A pip reflects a change in the value of one currency to another. As pip is a tiny percentage of the value of a unit of currency, you need to deposit large amounts to see considerable rewards. If you don’t have $100,000, you can use leverage. Depositing $1,000, you will be able to operate $100,000 using 1:100 leverage.
How Does Leveraged Trading Work?
Leverage can be applied to various financial instruments. It is important to understand that it differs regarding the asset it is applied to. Let’s review some examples to have a better understanding of how leverage trading works.
Trading on Margin
In the currency markets, the most common leverage is 1:100. It means you can trade up to $100,000 for every $1,000 in your brokerage account. The reason for such high leverage on the Forex is because leverage is a function of risk. Market makers know that if a trading account is managed properly, the risk would also be in control. Otherwise, they would not offer such leverage. The other reason is the significant liquidity of the Forex spot markets, which allows a trader to open a position much easier than in other less liquid markets.
In trading, currency movements are tracked in pips, the smallest change in price that depends on the currency pair. In reality, these changes are fractions of a cent. For example, when the price of the currency pair GBP/USD moves 100 pips, that is only 1 cent.
It becomes clear that currency transactions must be conducted in significant amounts. Otherwise, you won’t be able to earn anything. That’s why leverage is a common thing for Forex traders. When you operate $100,000, small price changes will result in significant gains. Still, remember that leverage raises not only potential profits but also multiplies losses.
Leverage in CFD Trading
Financial leverage in CFD trading also allows traders to have a smaller starting capital. CFD can be used for such instruments as stocks, commodities, and cryptocurrencies.
Let’s assume there is Stock 1. It’s currently traded at $5.00. A trader wants to buy 10,000 contracts of Stock 1. A broker offers a 10% margin. This means that the trader needs only $5,000 to purchase 10,000 contracts of Stock 1 (10% x $5.00 x 10,000).
If the trader didn’t use CFD and bought those stocks on the cash market, the price of the stocks would skyrocket to $50,000 ($5.00 x $10,000).
Leverage for Indices
Indices are used to evaluate the overall economic situation as they include a number of assets traded on a certain exchange. The overall price performance of the index is based on the price direction of the included assets. The NASDAQ 100, S&P 500, and the Dow Jones 30 are the most known indices that are widely traded. Indices usually have fairly low margin rates, which lead to high leverage ratios of up to 1:20.
Leverage trading is available for options and futures. However, when you deal with options, leverage depends on the premium. When you trade futures, you can get leverage through the margin mechanism.
The idea of leverage trading doesn’t differ. You can both increase your profit and loss. To decrease the risks, it is recommended that you lower the leverage ratio or the amount you control with your own funds. The lower the percentage you place as your initial deposit, the higher the leverage you have to change the price of the underlying financial instrument in any direction. At the same time, you get greater potential gains and losses.
ETFs are funds that track certain assets, such as indices and commodities. Index ETFs include a basket of assets of the tracked index. For instance, the ETF that tracks the S&P 500 index contains 500 stocks that the S&P index has. Usually, if the S&P changes by 1%, the ETF also changes by 1%.
A leveraged ETF that is tracking the S&P can use financial products and debt, which increases each 1% gain in the S&P to 2% or 3% in the ETF. The amount of the gain depends on the amount of leverage used in the ETF. Leverage is used to buy options and futures to amplify the impact of price fluctuations.
Still, leverage can also result in multiple losses for investors. Suppose the underlying index falls by the aforementioned 1%, the loss will rise by the amount of leverage. Thus, leverage can magnify gains or lead to significant losses. Investors should also keep in mind the risks associated with leveraged ETFs, as the risk of loss is larger than when dealing with traditional financial instruments.
Also, remember that management fees and transaction costs in trades with leveraged ETFs can reduce a fund’s returns.
What Is a Leverage Ratio?
A leverage ratio is a measurement of the exposure of your trade compared to its margin requirement. The leverage ratio depends on the market you are trading in, your partners, and the size of your position.
For example, a 10% margin would provide the same exposure as a $1,000 investment with a margin of only $100. Thus, a leverage ratio is 10:1.
Typically, if it is a volatile market, the more volatile it is, the lower the leverage offered to protect your position from sharp price fluctuations. However, Forex is an example of an extremely liquid market that can have high leverage ratios.
Let’s review how different leverage ratios can affect your profit potential and maximize losses, taking $1,000 as your initial investment:
What Are the Advantages of Leverage Trading?
Traders of all levels often use leverage trading because of its availability and exceptional convenience. In fact, it is also quite a transparent instrument with obvious advantages such as:
Increased capital for the transaction, which means you can open big positions even with your own small funds.
Leverage in trading lets traders make magnified profits on trades that go in their favor. Profits are derived from a controlled trading position rather than from margin. As a result, traders can make significant profits even with minor changes in the prices of the underlying assets. Still, remember that leverage raises not only potential profits but also multiplies losses.
Price movements can be predicted as they often occur in cycles of high and low volatility. This is a chance for traders to potentially make big profits during periods of low volatility. The same small price fluctuations can also entail significant losses.
Traders can enter the capital-intensive markets, even if they don’t have a lot of their own funds.
What Are the Risks of Leverage Trading?
It is clear that leveraged investment is in itself quite a risky undertaking. Therefore, it is necessary to understand what happens in case of unfortunate developments in the market.
If the price of shares or other instruments purchased with the attraction of a margin loan doesn’t go in the direction that was expected by the investor, or the value of other instruments from their portfolio decreases, the trading account balance may decrease too much. Then the broker sends a margin call to the client.
The margin call is a warning from the broker that the client’s funds are no longer enough to open new positions and secure current ones. Upon receipt of such alert, the investor must additionally deposit funds into the account in order to restore the possibility of securing his trades.
If the client is confident that the market situation will change soon, they can ignore the margin call for a while. However, if the market doesn’t get better, and assets continue to lose value, the broker will automatically close positions, which means selling stocks, currencies, etc., at the current market price. This will allow the broker to fully return the loan given to the investor.
Don’t fall into the psychological trap. Margin accounts provide free funds. Thus, it is easier for you to spend them. Beginner traders usually try to increase a losing position to get back what they have lost. It becomes even easier when you deal with lent funds. However, it’s important to keep your head cool, so you don’t gain unreasonable confidence in the potential profits.
No Long-Term Leveraged ETFs
Even buying leveraged stock ETFs involves risk. Most funds reset on a daily basis, meaning their goal is to match the one-day performance of their index. Over the long term, their returns can differ significantly from the overall return of the benchmark. For example, the SEC reported the increase of the index was up to 8% between December 1, 2008, and April 30, 2009. At the same time, the 3x leveraged ETF tracking the index fell 53%, and the 3x inverse ETF tracking the index fell 90%.
How to Minimize Leverage Trading Risks
When trading with leverage, it is important to minimize risks.
Use money management strategies. Choose one that fits you the most and allocate funds rationally according to it. Trade with caution and assess the risks. And most importantly, don’t try to develop fraudulent schemes using financial leverage - you will incur huge losses.
Regardless of the experience of the investor, it is always worth setting up a stop loss. This is a level at which a losing trade is closed. Stop loss protects the trader from large losses and all funds of the account.
Tips for Leverage Trading
At first glance, it seems that leverage trading is just for novice investors, but it has some nuances. Here are a few tips to keep in mind when dealing with leverage trading.
Make a trading plan. Use whatever strategy works for you. Don’t forget to do thorough research. Look for entries, exits, and stops, and stick to your plan to build a solid rationale for each trade.
Define the risk. A good trading plan is a key to success, especially when you define a goal and a risk. This is important for any trade, but for leveraged trading, it is the most important. A disciplined trader can have a 50% winning percentage and still make a profit. That is because they keep their risk in check.
Determine the amount you are ready to lose. Taking into account the risk becomes easier when you think about the actual money you are putting into a trade. Remember that losses are always possible and decide whether you can afford to lose, for example, $50 to make a $100 profit.
Be aware of fees and commissions. Trading with leverage is more complicated. Fees and commissions can increase. Think of all possible additional costs when opening a trade.
It is extremely important to protect the health of your account. To do this, you need to limit your risk and maintain discipline.
Leverage is a very powerful tool that allows you to multiply your income and trade effectively without a huge amount of capital in your account. However, like all powerful tools, it should be used wisely. Otherwise a trader can face big losses. A beginner should not take a high leverage and try to make huge profits right away. As long as you have a low amount of capital, use leverage of 1:2-1:30. Otherwise, you will lose all of your account equity if you fail. Don’t forget to set stop loss orders and work on reducing your risks. Define a strategy and develop a plan. Don’t be afraid of the first losses and keep gaining experience in this field.
IMPORTANT NOTICE: Any news, opinions, research, analyses, prices or other information contained in this article are provided as general market commentary and do not constitute investment advice. The market commentary has not been prepared in accordance with legal requirements designed to promote the independence of investment research, and therefore, it is not subject to any prohibition on dealing ahead of dissemination. Past performance is not an indication of possible future performance. Any action you take upon the information in this article is strictly at your own risk, and we will not be liable for any losses and damages in connection with the use of this article.
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