What is Leverage trading and how does it work?


What is Leverage trading and how does it work?

Reading Time: 25 minutes

1. Leverage Defined

Leverage refers to the ability of participating in a large investment by only paying a small percentage of the total value of the investment. It can be found in our day-to-day lives when we take out a loan to study or buy a house or a car. Most individuals cannot pay for their studies upfront or buy a house or car without assistance. So, they pay a small deposit as security and borrow the rest with the promise of paying it back later. This is what leverage allows people to do. Without it, people would not have access to more favourable opportunities and would need to settle for something less favourable.

2. Defining Leverage Trading

Leverage Definition

Leverage trading refers to the ratio applied to the marginal amount deposited. It is illustrated through ratios such as 10:1, 100:1, 200:1 and 500:1. So if a trader wants to invest 1,000 USD with leverage of 100:1, then that would mean that with 1,000 USD the trader will be able to hold a position worth 100,000 USD.

In trading, leverage can be applied across various financial markets such as stocks, commodities, exchange-traded-funds (ETFs), treasuries, indices and the largest financial market of them all, the foreign exchange. What needs to be kept in mind is that leverage acts like a double-edged sword. On the one hand it offers amplified potential earnings but on the other hand it also comes with amplified potential losses, so traders must exercise caution when applying it to their trades.

3. How Leverage Trading Works

How Leverage Works

Like when choosing to get a loan to buy a house, leverage trading requires a deposit upfront and comes with a form of interest and costs. So, suppose you buy a house for $500,000 with a 10% deposit and a 3% interest rate. In that case, you would have bought a house worth $500,000 with an upfront payment of $50,000 and the responsibility of paying 3% interest on the money borrowed. This is a ten to one leverage (10:1). If the property price rises to $600,000, the home buyer will have earned $100,000 on top of his initial investment. If the property value drops to $400,000, the buyer will be at a loss but still responsible for paying the interest rate.

Leverage trading works similarly, with the difference being that instead of talking about a house, it applies to financial instruments such as forex, commodities and shares. When trading with leverage, just like how house buyers need to be wary of associated costs that come with a housing loan, traders need to be aware of the associated costs with trading such as broker commissions, the spread and swap fees and associated risks like market volatility and market liquidity.

4. Terms to Know If You Want to Trade with Leverage

Leverage trading is the ability to enhance one's trade by allowing investors to take on a larger financial position than what they are willing or able to afford. It is described in ratios such as 10:1, 50:1 and 100:1.

Marginal trading refers to the act of paying a small/marginal amount as a security deposit of the total value of a trade.

A margin call occurs when a trade does not go as expected and the trader is requested to invest additional funds to maintain a position.

A stop-loss orderis a limitation that a trader can pre-set before entering a trade to exit a position at a certain point.

The spreadis the difference between a buying price (ask price) and a selling price (bid price) of a financial instrument. The wider the spread, the higher the risk of that financial asset.

5. The Connection of Leverage and Margin

Leverage and margin connection

For a trader to hold a leveraged position in a financial market, there is a margin requirement. This is margin trading. Leverage is the difference between the total value of a trading position and the amount of capital paid upfront. The margin accounts for the amount of capital paid upfront, held as a security deposit, to have a certain degree of control over that position. Higher leverage means a higher marginal cost and vice versa.

6. Types of Leveraged Products

Wherever you look across the global financial markets, you will be able to find a financial product that can be leveraged - some of the most commonly leveraged products are:

Forex market (FX)

The forex market, also referred to as forex or the foreign exchange, is the largest financial market in the world. It is well known for offering some of the highest leverages, which is one of the reasons why trading on a currency pair is so popular. It is a market that is open 24 hours a day, 5 days a week and allows for both day and night trading.

Contract for Differences (CFDs)

Leverage is of particular interest to professional CFD traders. This is because leverage through CFDs allows traders to take on a large position without ever needing to take physical ownership of the asset. This is why CFD leverage trading is more focused on correct speculation of price movement rather than the actual underlying asset itself.

Exchange Traded funds (ETFs)

ETFs are funds that hold a position in a pool of financial instruments. They usually represent a set of classes, and unlike mutual funds, ETFs can be traded on the public stock exchange like corporate giants such as Apple, Google and Amazon. Watch out for leveraged ETFs, as there are not designed for long-term holding periods. Or in other words, they are not intended for buy-and-hold investors. Look out for those power words like Bull and Bear multiplied by a three in the ETF name.

7. Pros and Cons of Leverage Trading

Paraphrasing from the famous words of Warren Buffet, the combination of ignorance and leverage can bring some pretty interesting results. Depending on the level of trading experience and knowledge, leverage can operate as a powerful amplifier to a trader's investment portfolio. Still, it can also be why a trader is forced to close their trading account.

The literature explains that the main benefit associated with leverage trading is the ability to magnify one's returns. For instance, with leverage of 100:1, a trader can invest $100 but have a stake worth $10,000. Obviously, the returns are different for someone that invested $100 than for someone that has invested 100 times that amount. So, with leverage trading, you don't have to be rich to be part of rich opportunities. But being part of rich opportunities also means being part of more serious consequences.

Simply put, leverage trading amplifies returns but also losses. The reality of trading is that it does not always go as expected. After all, no matter how much we would like to have a crystal ball that predicts the future, we do not. Instead, we try utilising to the best of our ability the trading tools in our procession to predict market activity as accurately as possible. But no one can guarantee any results. If a leveraged trade does not go as expected, just like how returns are amplified when the market moves in favour, so are the losses when the market moves in disfavour. In addition, a leveraged loss can also lead to the extra cost of a margin call, requiring the trader to invest more capital to maintain the position.

8. Markets Where Leverage Can Be Used

All sorts of markets allow leverage to be used. A very well-known one is the real estate market. In trading, investors can use leverage in many financial markets such as in forex, shares, commodities, indices, bonds, Contract For Differences (CFDs) and Exchange Traded Funds (ETFs). When using leverage in either of those markets, caution must be exercised. Some markets are volatile and risky as is. Holding a leveraged position in those markets does not only mean leveraging your financial position but also leveraging your volatility.

9. Focusing on Leverage Ratio and Its Formula

Leverage Formula

Traders open various positions to maintain a diverse portfolio and distribute risk. So when trading, it is important to know your net asset value and the accumulated value of your trading position. This is done by calculating the leverage ratio and position size.

To calculate your "Leverage ratio" you divide "Asset amount" by the "Margin amount".

Leverage = Asset amount ÷ Margin amount

To calculate your position (Asset amount), you multiply your "Marginal amount" by the "Leverage ratio".

Asset amount = Marginal amount x Leverage ratio

10. Example of Leverage Trading

Let's take an example of leverage trading in the stock market. Let's say you have $1,000 sitting in the bank, you suspect that the price of Apple shares will rise, and you want money to start working for you. So, you buy $1,000 worth of shares at the ask price of $200 with a 100:1 leverage. This means that although you have invested $1,000, with a 100:1 leverage, you will be holding a position 100 times greater than your investment, which in this case is worth $100,000 in Apple shares. If the price of the shares goes up to $250, then with your $100,000 investment, you will have earned $25,000. Had you invested only $1,000, your earnings would be $250.

11. How Much Leverage Is Ideal

The amount of leverage a trader chooses to hold can depend on many things. Some are more logical than others. You can choose to invest what you can afford or take the risk of over-extending yourself. What is advisable is to make sound decisions based on research, good advice and reputable sources rather than to engage based on emotion or a hunch. At the end of the day, the more effort one puts into making the right decision, the less exposure to risk they face. Beginners should start with low leverage to familiarise themselves first with the procedures and costs before exposing themselves to high levels of risk.

12. Effects of Leverage on Profits and Losses

Effects of leverage

The ratios of leverage speak for themselves. There is a difference between a trader entering the market with $1,000 than it is with $100,000. In the financial world, leverage allows a trader to hold 10 times (10:1), 50 times (50:1), or even 100 times (100:1) greater a position than what their capital allows for them. So, 10 times greater a position, 10 times greater the return. But also 10 times greater the loss.

The difference between profit and loss in leverage trading is that questions are not asked when a trader receives 10 times the return. They also don't have to face what is called a margin call, which is when the broker requires more capital to hold a trader's position. So before rushing to take on maximum leverage, it is advisable to start with low leverage and refine your trading strategy through a few trades, to minimise your risk and increase your opportunities for heightened earnings.

13. Risks and Risk-Management Tools in Leverage Trading

Regardless of your efforts, no matter how much research you do, there is always an element of uncertainty when it comes to trading. This is due to the nature of markets and human behaviour and the fact that you can't correctly anticipate all their activity at all times. When you add high leverage in the mix you will also get high risk on top of the uncertainty. However, this does not mean that you cannot mitigate that risk. For instance, there are powerful tools like a stop-loss or a take-profit order that allows traders to automatically exit a position at a specific price point.

A stop-loss order is one of the greatest tools a trader can have in their arsenal of risk-management tools. Stop-loss orders protect traders by allowing them to automatically close a position at a specific price point of their choosing. Different approaches can be taken when using stop-loss orders. Some traders argue that it is best done right at the beginning when opening a trade with a fixed stop-loss (in forex, this could mean a stop-loss of 50 or 100 pips, for example). Other traders believe that it should be placed based on support and resistance levels, which act as good indicators for when a trader should close their position to trim their loss.

In conjunction with a stop-loss order, a take-profit order can also be used. This works similarly with a stop-loss order, only this time, a take-profit order is a type of limit order that specifies the exact price when a position is closed for a profit. This may seem illogical to some because why would you want to put a limit on your profits. However, take-profit orders are a great risk management tool for short-term traders. This is because it removes the guesswork when closing a trade and limits the risk of exposure to any possible future market downturns.

14. Leverage Trading Platforms to Use

Trading Platforms to use

FP Markets' trading platforms MetaTrader 4 (MT4) and MetaTrader 5 (MT5) offer leverage trading, even up to 500:1, with real-time price charts, numerous technical indicators, market insights and risk management tools - designed with the commitment of delivering a seamless trading experience. Before you open a live trading account, FP Markets also offers a demo account for traders to have the opportunity of experiencing the platform and all its remarkable features prior to actively engaging in the financial world.

15. How to Choose a Broker to Help You

When choosing anything, each person has their preferences and driving factors. Some worth considering when choosing a broker is to ensure that the broker:

  • is regulated,

  • has good reviews,

  • is popular amongst traders,

  • supports advanced trading platforms,

  • provides access to risk management tools, and

  • has a demo account.

This way, a trader can lean on the accountability and transparency that regulatory authorities enforce on those brokers, learn from experiences faced by other traders and have access to trading tools developed to assist them in making sound trading decisions.

FP Markets is a globally recognised and awarded team committed to providing an unparalleled trading experience. They are regulated by powerful authorities such as the Australian Securities and Investment Commission (ASIC) and Cyprus Securities and Exchange Commission (CySEC). With over 40 international awards FP Markets has been recognised for its lightning-fast executions, superior partners program, advanced trading platforms, customer satisfaction and education material.

16. Open an Account Now

You can open a live account with FP Markets now and start trading with a minimum deposit of $100, a spread as low as 0.0 pips and leverage even up to 500:1. FP Markets provides access to over 100 products across forex, indices, commodities, stocks and cryptocurrencies. Amongst its lightning-fast trade execution, deep liquidity and other awarding winning products and services, FP Markets is a leader in its industry, committed to providing its clients with the best possible trading experience. FP Markets also offers a demo account, if you prefer to familiarise yourself with its facilities before trading live.

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Source - database | Page ID - 21158

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