This article, will define what leveraging in trading is and how traders should utilize it. The pros and cons of using leveraging will also be discussed.
What is Leverage?
Leverage is often expressed as a multiple or ratio. For example, if a leverage ratio of 1:100, the total investment is 100 times the trader’s principal. With this tool, your principal, or margin, is only a fraction of the total value of a trade.
What does leverage mean in trading?
In trading, leverage means trading more than principal by borrowing funds from your broker. You thus get to trade with less capital for higher returns. This guide will introduce you to this notion and how to apply it.
Here’s an example of how leverage can affect your profits or losses:
1/ You invest $1,000 in assets with no leverage:
- With every 1% increase in asset price, you earn $10.
- With every 1% decrease, you lose $10.
2/ You invest $1,000 and apply 10 times leverage.
Now, you can buy assets worth $10,000.
- If the price goes up 1%, you make a profit of $100.
- If the price decreases by 1%, you lose $100.
Borrowed capital magnifies your trading results. In our example, 10x leverage magnifies gains or losses from 1% to 10%.
Leverage and Margin
Margin is the capital paid in advance to your broker to use leverage. In essence, it is a credit deposit. Your broker uses this money to open and maintain positions.
The margin level is the ratio of the margin to the total amount of contracts bought and sold. It is also known as the leverage ratio or ratio.
Margin Level = 1 / Leverage Ratio
If the margin level is 0.2%, then the ratio is (1/0.2%) = 500x
Investor Capital (Margin) = Total Trading Value / Leverage Ratio
To trade a $10,000 contract with a leverage of 500 times, you’d need to put in at least $20 as a margin to open a position ($20 = $10,000/500x).
$20 is the initial margin required to open the position. There is also a minimum margin requirement (or margin call) in the general trading rules, such as 20% and 30%. Establishing this ensures that the margin investors put in is maintained at a level that can offset the potential losses from holding contracts.
Using Trading Leverage: the Pros and Cons
The most significant benefit of leveraged investing is that it can bring greater profits to investors. Leveraged trading offers quite a low threshold for entry. Therefore, you get to capture more market opportunities with a small initial investment.
However, when a position goes against you, this multiplies losses, just as it magnifies gain. If you misuse this tool without risk management, you create additional risks for yourself.
Thus, if you choose to use leverage, be aware of the risks this involves and carefully control the degree of use. You should also develop strategies to avoid unnecessary losses, as explained below.
1. Use Stop Loss
Stop-loss limit losses by closing your position at a pre-set price when the market isn’t in your favour. You either set it according to market prices or choose a specific amount.
2. Use Take Profit
Take-profit allows you to close positions automatically when you reach a set target price. This prevents you from missing opportunities to sell while away from your desktop or trading app.
3. Negative Balance Protection
If the net value of your account becomes negative, some brokers fill in your losses and reset your net account value to zero.