What is Leverage trading and how does it work?
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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 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
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
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
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
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
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.