When operating in the financial markets, we can make an investment with our available funds or resort to indebtedness to face said investment; is what is known as financial appeceament.
In this sense, leverage would work like a mortgage, in which you give an entry (which would be the margin we pay) and you receive a house (in trading, the financial asset).
What is Leverage in Trading
The trading leverage it means being able to operate with more money than is actually available in the broker’s account. That is, it could be defined as a operational ease offered by the broker to the investor, allowing you to trade with positions greater than the amount of funds in your account.
Although leverage allows you to multiply your profits by the forex market, it also increases losses in case a position turns against you. Therefore, beginner traders and those who start trading in Forex or CFDs have doubts about financial leverage. In this article we will try to answer all your questions.
How leverage works in trading
We have already seen that leverage consists of the possibility of operating with borrowed capital in the financial markets. That is, for a trader it means being able to operate with larger volumes than he owns and, therefore, you can access markets that are often inaccessible to you.
To express leverage, a multiplier is often used that shows how many times the amount of an open position is compared to the actual amount of the trader’s funds used on that position.
For example, if the trader wants to make a trade with a leverage ratio of 1:10 it means that he only needs 1% to open a position. With €1,000 initial deposit you can get an exposure equivalent to €10,000
In the Forex market you can get to operate, with some brokers, up to a leverage of 1:500. This means that for every euro that we have in our account we can move 500 euros in the market.
For each position and instrument that we open, our broker will specify a margin required as a percentage. The margin can be considered a form of guarantee for the short-term loan that our broker makes us together with the instrument itself. That is, it is the minimum amount that we must maintain in order to continue operating.
There are a number of essential concepts that an investor trading with leverage needs to know:
- Margin: is the amount required by the financial intermediary (broker) to cover a possible loss. Margins are typically calculated as a percentage of the position value.
- capital invested: total amount of the operation.
- venture capital: amount of funds in the investor’s account that can put the operation at risk.
- Stop loss: In order to limit the risk capital, the investor must define and apply the ‘stop-loss’, that is, the price levels for which the operation is closed automatically, cutting the losses.
Margin in Leverage
Leverage and Margin are two concepts that are associated. As we have anticipated, the margin required by the broker is the funds that are needed to open and maintain a trading position with leverage. It is the difference between the total value of your position and the funds that have been lent to you by a broker.ro a leveraged trading provider.
To better understand the concepts of leverage and margin, let’s see it with a practical example:
You would like to open a position of €100,000 and your account leverage is 1:100. Therefore, your broker requires €1,000 from your account, as margin.
Suppose this position makes a profit of 1%. That means that you will have won €1,000, that is, 100% of your total invested capital. With this example, you can see that if the position loses 1%, you will have lost 100% of your real investment.
Margin is a percentage of the leveraged position that is opened. In the example that we have set, the margin is 1%. Both the leverage capacity and the margin are determined by your broker.
In other cases, margin can be 0.5% of the size of the traded position with a leverage of 1:200. Other brokers may only require a 0.25% margin or 1:400 leverage.
Some brokers offer very high leverage ratios. It’s tempting, a beginner trader can make a lot of money with very little investment. But, as we have seen, they can also lose everything in a single operation.
Expert traders are not easily fooled. They usually operate with margins of 1% or 2%.
In which markets you can use Leverage
The CFDs are contracts for difference where the profit or loss is the difference between the entry price of the position and the closing price of the position.
The most popular leveraged instruments include:
- major currency pairs like: EURUSD, GBPUSD and USDJPY
- commodities such as: gold (XAUUSD), crude oil (OIL.WTI) and coffee (COFFEE)
- stock indices: DAX, S&P 500 and NASDAQ 100
- Cryptocurrencies like Bitcoin and Ethereum
- CFDs on shares such as: Facebook, Amazon.
How to minimize risk when investing with leverage
The money management in trading It is the part of the investment that is responsible for studying the best way to operate to obtain the highest profitability and control risks. For this reason, this concept is also called risk management and it is one of the pillars of trading.
The main purpose of trading is to make money. However, this does not mean that you should risk all of your capital on every trade. Managing money wisely is the real key that separates success and failure. Many traders struggle at first because they underestimate the importance of money management in their investment strategy and that, in leveraged markets, puts their capital at risk.
It is important that you set predefined risk levels (1% or 2%) so as not to lose your trading account in one day. This 1% or 2% risk per trade figure is a good middle ground between risk and capital conservation, because it allows you to earn more than enough on winning trades and conserve capital during losing streaks.
At Traders Business School we have designed a very valuable tool for trading: the indicator Easy Order that automatically calculates the lot to enter based on the risk per operation. This way you avoid entering the market with more risk than you can afford.
- You just have to set the percentage of the account to risk and visually the level of the stop loss and the program will enter the market with the appropriate lot for your account.
- To avoid problems, calculate your losses before opening each trade that involves leverage. The leverage ratio you use should be appropriate for your risk profile.
- Use the stop loss in all the operations you carry out. To create stop losses, you need to know in advance what your risk/reward ratio is. This will greatly help you take care of your money and avoid bankruptcy.
Advantages and Risks of Leverage
We already know what financial leverage is and how it works, but what consequences does it have for a trader? Next, we are going to present the main advantages and disadvantages of this type of investment.
Advantages of Leverage
First, the leverage allows investors to have more capital, since only a fraction of the value of the assets in which they are interested is committed, that is, the investor only has to pay a part of the total position. If this mechanism is used effectively, the investor can obtain a higher return than would be the case with direct participation.
However, these operations entail risks, so constant monitoring and control of the position is essential. When performing a leverage trade, the investor must check if the cost of the debt is less than the possible return that can be obtained. In no case should the investor leverage if he does not have sufficient capital to cover any possible loss.
In addition, leverage allows investors the ability to acquire high-priced financial assets that they would not otherwise be able to acquire.
As you can see, there are many advantages, but in order to obtain benefits with leverage we must have a previous base, good training in this matter and, in addition, operate for a time in demo to practice trading, learn to use leverage and perform good money management.
Disadvantages of leverage
Although greater exposure can be beneficial, it can work against the investor and multiply their losses:
- If the market moves in the opposite direction to the desired one, it is possible to lose more money than was originally invested, and even go into debt.
- Leverage operations have to be carefully studied by the investor in order to minimize the risks.
- In case of loss, the rate of return on investment is reduced.
At DTP we trust that this article has been of great help to you and that, after reading it, you will better understand what financial leverage consists of, what margin is, how leverage is calculated and its consequences on your trading strategy.
It is important to remember that trading leverage involves risk and therefore you can lose your investment by trading with high leverage.
The most advisable is avoid high leverage level until you have enough experience in the world of trading. The demo stage, trading in simulation, will help you learn how to use trading tools such as leverage. Once you have acquired the necessary experience, you will be able to put into practice everything you have learned in a real trading account.