Leverage is a complex and risky financial instrument operating on the basis of mathematical models that allow traders to vary the size of their deposit depending on the price of the asset, the volume of its purchase, as well as the margin regime.
Leverage trading (sometimes “leverage trading”) is the process of buying (long) or selling (short) financial assets using borrowed funds on an exchange or from a broker, which are traded at a certain rate set individually by each trading platform. Trading using leverage is similar to getting a loan from a bank. So, by buying a car with credit money, transport acts as collateral. If the borrower is unable to fulfill his financial obligations to the bank, the debt will be repaid at the expense of the collateral asset. In margin trading, money or securities held on users’ balance sheets serve as collateral.
Trading using leverage usually implies that in order for a trader to take additional capital to increase the volume of a position, he needs to deposit a small amount of equity as collateral, which is called margin. In other words, in order to use the leverage of a trading platform in any financial market, you must first have a certain minimum amount on your deposit, which also varies greatly depending on the trading platform.
If we talk, for example, about the stock exchange, then it is allowed to open a position with leverage only on the most traded (liquid) securities. It is also allowed to trade shares of exchange-traded funds, currency or derivatives (futures contracts). Each brokerage firm compiles its own register of assets for “lending”.
Trading using leverage allows you to open long and short trades. In the case of the cryptocurrency market, almost all cryptocurrency exchanges allow you to open transactions with leverage on all available assets, with the only difference that the size of the leverage may be different. The peculiarity of trading with leverage in the foreign exchange market is that its ratio is predetermined by algorithms and is not subject to regulation.
The financial leverage ratio is calculated using the financial leverage ratio formula as the ratio of total debt to total equity.
How does leverage trading work?
To start trading using leverage, a trader is recommended to start with a leverage that is less than his maximum allowable leverage. This allows traders to keep their positions open in full, even if they receive negative profits.
Trading using leverage is more suitable for those who trade short-term price movements. To a much lesser extent, it is suitable for those who are engaged in long-term investment, for example, for several years or even decades. In this case, the “buy and hold” approach would be more appropriate.
Example of leverage in stock trading
For example, let’s say a trader has a maximum leverage of 5:1 and opens a position on Apple shares with such a leverage on an account of $ 10,000. Now the trader has a position with an asset value of $ 50,000, which gives him the opportunity to trade 5 times more shares compared to if he had purchased these assets immediately, without using leverage on a starting account of $ 10,000. To maintain such a position on Apple shares using leverage, it is necessary that the value of the trader’s account does not exceed the requirements for a supporting margin of 50%, or 5,000 in this example. Learn more about supporting margin and margin calls.
Risks of leverage
The most important thing to understand when talking about leverage is the risk associated with it. Risk is inherent in any type of trading, however, the use of leverage can lead to both an increase in profits and losses. It is advisable for traders to pay special attention to choosing the size of leverage. The leverage ratio must be determined in advance. It is very tempting to trade in a larger amount than was originally determined if you have a winning streak of trades.
Doubling the risk on a one-time basis can benefit the trader if this one-time transaction turns out to be successful. If it turns out to be wrong, then the trader may face much larger losses than usual. To reduce the risks in trading, it is necessary to plan your trading strategy in advance.
When determining the amount of leverage for a portfolio, two factors can be taken into account: the amount of risk per transaction and the amount of risk per day. If we consider this question as a percentage, then everything becomes easier. First, the trader can determine what risk he is willing to take on the day. To do this, you need to determine the maximum amount that you are willing to lose. For example, it can range from 1% to 2%. If a trader uses 2% as the maximum daily risk, then in order to nullify his capital, it will take 50 days of unsuccessful trades in a row, which, I hope, is extremely unlikely.
The trader must also determine how many trades he wants to make per day. This can be a set or maximum number. For example, a trader may decide that in any market condition, he will make no more than three transactions per day. In each case, the trader can divide the percentage he is willing to risk per day by this number.
Leverage is an excellent tool for increasing potential profits, which is very popular among professional traders. Large leverage in most financial markets allows you to get more freedom of action with limited start-up capital. However, on the other hand, regardless of the level of leverage used, one should always keep in mind the risks that are equal in equal proportion to the potential profit that a trader seeks to obtain. Using a good trading strategy, money management and risk management will help you achieve excellent results when trading any assets, especially the most liquid ones.