Guide to Leverage trading

Leverage Trading Pros and Cons:
How Does It Work?

In finance or business, the term “leverage” refers to the strategy of using borrowed funds to acquire assets rather than your own equity or capital. The funds are borrowed with the expectation that the asset purchased will generate higher profits for the borrower.

In trading, “leverage” is a facility offered by brokers, which allows traders to acquire more financial instruments than the amount of capital they have in their trading account. In other words, this facility allows traders to use funds borrowed from the broker to increase their market exposure or trading position, with the expectation of increasing the returns on investment.

When using leverage, the trader needs to invest only a fraction of the total position. The remaining sum is borrowed from the broker to take a preferred position in a trade. There is no interest charged on the additional funds offered by the broker. Essentially, there is no cost of capital. It is however important for traders to be aware of how leverage trading works in order to use it effectively and manage the associated risks.

While leverage trading is hugely popular, especially among forex traders, it has pros and cons. By increasing exposure, a trader not only increases possible profits, but also potential losses, depending on the direction in which the market moves. Leveraging is a key trading strategy and is part of the standard offering of forex brokers. In order to understand how leverage trading works, it is important to explore the pros and cons of this investment strategy.

How Does Leverage
Trading Work?

This trading strategy allows traders to use only a small deposit amount to take a higher position in the financial market. The ratio between the value of the trade position and the investment required is known as the leverage. The percentage of the trade position that a broker is required to have in their trading account is referred to as the margin.

While leverage trading is often used synonymously with margin trading, these terms look at the equation from different sides. While leverage defines the maximum exposure you can get with one unit of your capital, margin defines the amount of funds needed in your trading account to open a specific position. For instance, if the leverage ratio is 20:1, it means you can open a trade that is 20 times your initial investment. This also means that you need only 5% of the value of the deal in your trading account. In simple terms, leverage allows traders to increase their buying power.

Different brokers offer different leverage amounts and have different margin requirements. Here’s a quick look at the common leverage ratio and margin that brokers offer.

Leverage allows traders to gain greater exposure in the market and is an industry standard with respect to forex trading. It can be used for trading various financial instruments, such as forex, commodities, indices, cryptocurrencies and more.

Understanding Leverage Trading
with an Example

Let’s say you wish to open a position on the popular currency pair EUR/GBP, when the rate is 0.9031. You expect the British pound to appreciate against the euro and your broker allows you leverage of 100:1. What does this mean? It means if you invest £100 in this currency pair, you can get exposure of £10,000.

Now let’s say the market moves in the direction you expected and the pair advances by 100 pips. This means the exchange rate rises from 0.9031 to 0.9041. When this happens, you make a profit of £100. So, just by investing £100, you have made a profit of £100! This equates to a return on investment of 100% (£100 profit on £100 investment).

To fully understand what just happened, let’s say you decided to trade without any leverage. In such a scenario, you would have invested £100 instead of £10,000. When the currency pair moved 100 pips, your profit would have been £1 and your return on investment would be just 1% (£1 on £100). That doesn’t sound exciting! So, you decide to invest the complete £10,000 on your own, without using leverage. Now, when the currency pair moves higher by 100 pips, you’ve booked a profit of £100. Before you begin feeling happier with the higher profit, let’s look at the return on investment. It is still only 1% (£100 on £10,000)!

What if your broker offers leverage up to 30:1? This means by investing £100, you could gain exposure of £50,000. With the same 100 pips movement in the currency pair, your profit would be £500 and your return on investment will be 500%.

While all this may sound extremely exciting, what you need to remember is that leverage not only magnifies your profit potential, but also increases the exposure of your trading capital. If the market moves against your expectation, you will book higher losses than what you would have without leverage. The use of leverage should be done with great care, with an understanding of it critical for those who are looking to start trading.

What are the Pros of
Leverage Trading?

One of the main benefits of leverage trading is that it gives you access to additional funds for a particular trade position. This means you can gain much more exposure to the financial instrument of your choice than was otherwise possible for you.

While you have access to more funds, there is no interest to be paid on them. If you were to take a loan to purchase any other asset, there would be a cost of capital (the interest payable). However, when trading with leverage, your broker offers you the facility of accessing more funds to acquire a financial instrument without charging any interest on the sum borrowed.

Leverage magnifies your profit potential. As seen in the examples above, it is possible to gain exposure of £10,000 or even £50,000 by investing only £100. Provided the market moves in your favour, your profit increases manifold.

You can begin trading with as low as £100. With leverage trading, even this is good enough for gaining exposure to larger positions and more expensive instruments, as you do not have to pay the full price for them.

Instead of keeping a meaningful amount in your trading account, you can divert the funds to other investments. This is because you are required to have only a fraction of the value of your trade position in your trading account.

What are the Cons
of Leverage Trading?

There are two sides to every coin and the same holds true for leverage trading. While it can magnify your profits, it can also magnify your losses. For instance, consider the above scenario where you take a trade position on the EUR/GBP currency pair with a leverage of 100:1. Here, you use an investment of £100 and gain exposure to £10,000 at an exchange rate of 0.9031, with the expectation of the British pound appreciating in value.

However, in this example, the market does not move in the direction you expected, and the exchange rate declines from 0.9031 to 0.9021, or 100 pips. In this scenario, you would book a loss of £100.

You could potentially lose more than the amount in your trading account. If your losses exceed the balance in your trading account, your broker can initiate a margin call to ask you to transfer more funds into your account. Due to trade losses, your account can become negative, unless you choose a broker that offers negative balance protection. In the absence of this, your broker can either demand a specific amount to cover the losses you have made or ask you to close some of your open positions. If you are unable to fulfil the margin call requirement, the broker may go ahead and close all your positions.

As a trader, it is important to understand your risks along with profit potential. Seasoned traders not only adopt various risk management strategies but are also aware of events that can lead to heightened risk, such as data releases, geopolitical tensions, or regulatory updates. For instance, the US NFP (non-farm payroll) is probably the most market-moving economic data release. Some traders choose to close positions a day before the release and wait for the market to settle after the release before opening positions again. News updates on the US-China trade tensions or the Brexit negotiations have also caused volatility in various asset classes. Being aware of such events is important in making better trade decisions, even if you are using technical analysis to determine entry and exit points.

Your broker may offer high leverage, but you need to choose the amount of leverage you wish to use with each trade. This will depend on your financial goals and risk-taking capability. If you are not well versed with the workings of leverage trading and the associated benefits and threats, you may end up forgoing profits or taking on too much risk.

How to Select the Most Appropriate Leverage
for Your Trade?

The amount of leverage you choose depends on a number of parameters. If your aim is to take positions in short-term trades and gain small profits, you can opt for low leverage and achieve your objective. However, if you are aiming for slightly longer-term trades and bigger profits, you may need to opt for higher leverage. However, high leverage brings high risk with it. So, if you wish to use leverage for even longer-term trades, it may be a good idea to choose less leverage, so that a sudden price movement does not wipe out your gains.

It is also important to consider your risk appetite. If you are averse to risk then it is probably better to be very conservative when opting for leverage. On the other hand, if you are using capital that you don’t mind risking, you may choose slightly higher leverage.

There is no right or wrong answer when making this decision. Finally, your financial circumstances, experience as a trader, and performance to date will play a key role in the decision. Moreover, not all trades need to be placed with the same leverage. You can vary the leverage according to your portfolio.

How to Limit the Risk Associated with
Leverage Trading?

The global financial market presents incredible trading opportunities. However, one cannot take advantage of these opportunities without assuming some degree of risk. Often the potential for higher returns is accompanied by higher risk. For instance, when there are wide price swings, a trader has the potential of making a larger profit, but also runs the risk of losing more than they would have in a stable market.

Same is the case with leverage. The higher the leverage you use, the higher the profit potential, as well as the associated risk. So, one of the ways of limiting risk is to limit the amount of leverage you use.

The asset class also makes a significant difference. There are some assets, like gold, which are less prone to price swings, while other assets, like cryptocurrencies such as Bitcoin that experience wide movements. As leverage magnifies the impact of price movements on a trader’s bottom-line, a way to limit risk is to use lower leverage for assets that have steeper price swings.

On the other hand, in case of asset classes that are typically less volatile, using adequate leverage makes it possible to increase the position size and market exposure and, therefore, book gains even from low levels of price fluctuation.

Knowledge and experience play a critical role in the effective handling of leverage trading. While reading and watching videos can help, there is no substitute for actual experience. You can gain hands-on leverage trading experience by opening a demo account and practising in live market scenarios. The only difference is that you gain experience with no-risk virtual money. Once you understand the workings of leverage trading and its pros and cons, you can proceed to live trading.

Novice traders sometimes use all the leverage that their broker offers. The best way is to begin gradually, taking low leverage initially and increasing it as you see it working for you. Once you’ve got a few successful leveraged trades under your belt, you can increase your leverage and market exposure.

Limiting risk is not just about by lowering leverage. Good risk management strategies can help lower the risk profile of a portfolio. The most important risk management technique is to place stop loss and take profit orders with every trade position. A stop loss order will contain your losses in case the market moves in the opposite direction to what you had expected. Stop loss will close your order before prices swing too much, keeping your losses to a minimum. A take profit order will ensure you book gains in time, before the market starts moving in an unfavourable direction.

What to Keep in Mind
When Trading with
Leverage?

Before you begin leverage trading or any kind of trading at all, ensure that your broker is regulated by one of the leading regulatory authorities like the FCA (the UK’s Financial Conduct Authority), the CySEC (Cyprus Securities and Exchange Commission) or the ASIC (Australian Securities and Investments Commission). These regulatory authorities require the broker to have segregated accounts, which ensures that the broker has no access to the funds in your trading account. The regulatory authorities also have stringent checks in place to prevent financial malpractices.

The impact of delayed trade execution is also magnified when using leverage. To avoid such delays, choose a broker that promises ultra-fast execution (under 40 milliseconds). Also, make sure your broker has a reputation of low latency, minimal slippages, high liquidity and no requotes, so that you do not miss out on critical pips in the time between your order placement and the actual order execution.

Another thing to verify is that your computer and internet connectivity are stable and have good speed. The choice of trading platform is also important. The most popular choices are MT4 (MetaTrader 4) and MT5 (MetaTrader5) platforms, which are robust and fast. Trading CFDs on these platforms has the added benefit of risk management features that enable you to manage leveraged trading positions more effectively.

This is where it is important to understand the concept of slippage, which means there is a difference between the price at which you expect to book a trade and the actual price at which the trade gets executed. This can occur during periods of low liquidity in the market. It may not mean that you record a loss, but you don’t want to be unsure of the amount at which your trade gets executed. The best way to avoid low liquidity is to check the difference between the bid price and the ask price. If this difference is low, you can rest assured that there is enough liquidity. You could also choose a broker that ensures top-tier liquidity and tight spreads. You can also look for award-winning, reputable brokers to be assured of the best trading conditions.

Once you have chosen a forex broker, the most important factor to consider when using leverage is volatility – both of the overall financial markets and the asset class in which you are considering taking a leveraged position. While volatility presents exciting trading opportunities, it also brings heightened risks, and the impact of both is magnified with leverage. Remember to diversify your trading portfolio and taking positions on a variety of assets. Trading CFDs in cryptocurrencies can be offset by a stable currency pair such as the EUR/USD.

Avoid having too many open positions at the same time. Doing so while using high leverage puts your trading account at significant risk. Too many open positions for too long increases the risk profile. It’s a good idea to open only as many positions that you can monitor and manage easily. Experienced trading also place a variety of order types. You will not see them always shorting a stock with stop-loss orders part and parcel of every risk management strategy.

Stay updated with market news and events. Some news releases can change the direction of the market and not being in touch with these events when you have open positions using leverage can have an adverse impact. Of course, the best way to prevent your trades from being overly impacted by such events is to open stop loss orders with every trade. However, if you are aware of a key government policy decision or economic data release is scheduled for that day, you may want to reduce your open positions or completely close them.

Avoid taking trade positions in assets that typically have low liquidity. When an asset has less liquidity, you may not get a fair chance to exit the trade position at your preferred price, when the situation demands. It’s a good idea to trade in popular financial instruments and stay away from more exotic ones, like the EUR/TRY (Euro/Turkish Lira) or the USD/ZAR (US Dollar/South African Rand). As these are not so regularly traded, they have low liquidity.

As a margin trader, your calculations become even more important, as minor inaccuracies have a more meaningful impact on the actual profit or loss each trade makes. Take into account all costs charged by your broker, including commission, holding charges and transition fees.

Why Use CFDs for
Leverage Trading?

CFDs (contract for differences) are financial instruments that are used for trading price movements without buying or selling the underlying asset and without considering the asset's underlying value. CFDs are leveraged products and offer much higher leverage than traditional markets. This means they offer great potential returns with a lower capital outlay for the trader, although this comes with a higher risk.

CFDs have gained immense popularity as they offer trading opportunities in both rising or falling market.

CFDs can be used for trading various asset classes, including forex, indices, commodities, and cryptocurrencies. Seasoned traders often use leveraged CFDs to hedge their existing portfolio, which may include physical shares or gold EFTs.

The Bottom Line

Leverage allows traders to gain more exposure to financial instruments with minimal capital investment, which increases the profit potential. At the same time, leverage also increases the chances of losses, which is why it is important to be disciplined in risk management when trading with this approach.

It also helps to keep your emotions in check, as price fluctuations create a higher impact in leverage trading.

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