Most brokers offer their clients leverage facilities as a means to increase their trading capital.
Leverage is basically a loan you take from your broker to get a good start on the market. Leverage increases your potential trading profit, but it makes the risks greater as well.
Brokerage accounts enable the use of leverage through margin trading.
Leveraged, or margin, trading is a facility provided by countless brokers as a way to increase the value of the trades. This basically means that the trader is able to open positions that are much bigger than the ones they were initially able to afford. Although it increases the potential reward, it amplifies the risks too.
To trade with leverage, the trader only needs to invest a certain percentage of the amount of the full position. The percentage varies depending on the amount the broker offers, the amount of leverage the trader would like to go for, and last, but not least, the regulating authorities in charge of overseeing the online trading field in this jurisdiction.
Nowadays, leverage is quite popular among professional traders, whereas amateurs should try resisting the temptation of using leverage.
The term itself usually refers to the ratio between the position value and the required investment. For example, you are placing a trade for $50. In this case, using the leverage of, let’s say, 400:1 will multiply the trade 400 times, which now makes it $2000. Now, instead of making a profit of $50, you can end up with $2000.
Unless you are offered tools that will ensure you can’t have a negative balance (which usually just opt you out of trades before your balance goes below 0), you are at risk of having your losses multiplied by 400 as well.
Don’t forget about the “margin”, which is one of the most important numbers in your trading account. The margin is the amount of money you are putting forward and is considered to be some sort of security deposit for the broker.
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Pros and Cons of Leveraged Trading
Pros of Leverage
- Leverage decreases the capital required for the trader to invest. Instead of putting in the full amount to open a position, you only use a certain percentage of your budget.
- Some assets are relatively cheap and, therefore, affordable for most traders. Some other assets, however, are far pricier and can be out of reach for most investors. Leverage allows you to be able to trade with the “premium” assets as well, not leaving you behind, whenever there are opportunities on the market.
Cons of Leverage
- While margin trading requires less financial commitment, which can be a huge advantage for many traders, it also brings huge financial risks to the table. It is absolutely essential to keep track of all the positions you have opened and use risk management tools in order to avoid huge losses. This is why the brokers usually request that the client make an additional deposit.
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Example of Leverage Trading – Retail Clients
Here is another example of margin trading. Let’s say you are trading with Gold this time. The price of one Troy ounce of gold is $1,327. You, the trader, believe that the price is going to rise dramatically and want to open a huge buying position for 10 units.
The position you want to open will cost $13,270 in this case, which is a pretty huge amount of money many people do not possess. If you use 20:1 leverage or a 5% margin, the amount will decrease by a great deal. In this case, you will only have to invest $1 for every $20 in the position, which brings the amount down to $663,5.
Risk Management – How it Works
In order to be able to apply leverage to trade forex, the trader must have enough funds in their account to cover potential losses. The requirements regarding the amount vary from broker to broker. Some platforms require around 50%, whereas some set the minimum a bit higher.
Let’s take the example from the above to explain the mechanism. The position’s original value is $13,270. Using leverage allows the trader to only use $663,5 of their capital. If they have 50% of the amount ($331,75) remaining, their positions will be open.
If the trader is losing the position and their equity drops below 50% (which is $331,75 in our case), the broker shuts the position down. Different platforms approach such situations in different manners.
Whereas some shut down all positions right away, others only close the biggest losing position first and continue to close the rest up until the moment the equity level is above 50% of the margin.
Example of Leverage Trading – Pro/Non EU Clients
Let’s take the Gold example. The price of one Troy ounce of gold is $1,327. You, the trader, believe that the price is going to rise dramatically and want to open a huge buying position for 10 units.
The position you want to open will cost $13,270 in this case, which is a pretty huge amount of money many people do not possess. If you use 200:1 leverage or a 0.5% margin, the amount will decrease dramatically. Now you only have to invest $1 for every $200 in the position, which brings the amount down to $66,35.
Risk Management – Pro/Non EU Clients
In order to use leverage, a trader needs to have enough funds in their account to cover any potential losses. Each broker has its own minimum amount requirements, some go as low as 10% for Non-EU traders.
Let’s come back to the Gold example for another instance. The position’s original value is $13,270. If applying leverage and investing $66,35, the trader only needs to have $6,64 for the positions to remain open.
If the position is causing losses and the equity is less than 10% of the used margin, the broker will be shutting the positions down. Different platforms approach such situations in different manners.
Whereas some shut down all positions right away, others only close the biggest losing position first and continue to close the rest up until the moment the equity level is above 10% of the margin.
Leverage Main FAQs
Q. Can the use of leverage lead to a negative balance?
Thanks to the margin requirements and risk management tools, the risk of you going overboard with the losses is minimal. It still exists, however. During extreme volatility, you may not be able to liquidate your losing position and avoid having a negative balance in time, because the positions will be moving against you too quickly. This is why it’s important to use leverage wisely.
Q. What is the difference between leverage and margin?
Leverage and margin are quite similar, but they are not the same. Both are based on the idea of borrowing in order to go big on the financial markets, but while leverage only refers to the act of taking the money, the margin actually is the money the trader has taken to open a position. Leverage is a ratio (1:10, 1:300) that indicates how much debt you can possibly take to open a certain position, whereas margin is the actual amount you are borrowing to create the leverage. For example, 1:100 leverage lets you control $100 of an asset with $1 in the margin.
Q. Does leverage have any disadvantages?
Leverage is a complex trading tool that should be taken seriously. While everyone loves the part about increasing earnings, they tend to forget the part about the amplified risk. Any leveraged trade gone wrong will bring on bigger losses for the trader than a regular trade would have. Therefore, it is recommended to restrain yourself from using it before you become a bit more experienced. This approach will lead to a more successful and stable trading experience.