Leverage in trading is a way to trade that allows you control over a large position on the stock market for a lower amount of money. The broker lends you money to increase the amount of your trade. While it can increase profits, This also increases risks as the losses are magnified.
Here’s a simple way to break it down:
What Is Leverage?
This means using borrowed capital to increase the power of your trading. Borrowing money from a broker allows you to trade with a larger amount of money than what is in your account. This allows you to trade with more money than is in your account.
Leverage is usually expressed as a number, like 2:1, 5-1, or even 100-1, depending on the market, broker, and other factors.
How Leverage in trading Works in Practice:
Example 1 (Without leveraging): Suppose you have $1000 in your bank account and wish to buy shares that cost $50 each. Without leverage, your $1,000 can buy 20 stocks (20 shares * $50 = $1,000).
Example 2 (with leverage): Let’s say your broker provides you with a 10 to 1 leverage. You can control $10 in stock for every $1 you put into your account. You can now buy $10,000 worth of stocks with just $1,000. If you want to buy more than 20 shares of stock, then you should purchase 200. (200 Shares x $50 = $10,000.)
Why Traders Use Leverage:
Here’s a way to increase profits: The profit would differ if the share price increases by $5.
If you own 20 shares of stock, then your profit would be $100 ($5 x the 20 shares).
If you own 200 shares of stock, then you would make $1,000 in profit (5 x 200 shares).
Leverage has allowed you to earn more money by investing less.
The Risk of Leverage in trading:
This can increase your profits but also your losses when the trade is against you.
An Example of a Leveraged Loss: Let’s assume that the stock price falls by $5 instead of increasing. The losses will be different:
If you don’t use leverage, you would lose $100 ($5 divided by 20 shares).
If you use leverage, you could lose up to $1,000 ($5 divided by 200 shares).
Leverage has multiplied the losses in this case by 10 times. If the trade fails, you could lose your entire initial investment.
Understanding Margin:
When using leverage, your broker will require you to put down a certain amount as collateral. The margin is what we call it. This is called the margin.
For example, if you have a leverage of 10:1, your margin requirement could be 10%. To control $10,000 in stock, you need only $1,000 as margin.
Margin Call
Margin calls occur when losses are so large that the broker asks you to deposit more money into your account to cover them. Brokers may close their positions if they do not add additional funds.
Ex: If the stock price drops significantly and you have $1,000 in margin, the balance on your account could fall below the required margin. If this happens, your broker will call for a margin deposit, and you will need to make a new deposit to maintain the position.
In this case, the broker may sell your position to avoid further losses.
Leverage Ratios:
Different markets have different leverage ratios. The following looks at how leverage may vary across different trading types.
Forex trading offers high leverage. This can be up to 100:1 and 500:1, which allows traders to manage large positions using small amounts of capital.
Stocks:
Stock markets are less volatile and offer lower leverage (typically 2:1 or 5:1) than forex or commodities.
Commodities are traded with a higher leverage than other assets, like oil or gold. This can be as high as 20:1 or 10:1.
Advantages of Leverage:
You can take advantage of smaller price fluctuations and control larger positions.
Low Capital Requirement: You do not need a large amount of capital to make big trades. This can maximize your trading potential.
Potential for Higher Profits Leverage is a powerful tool that can increase your profits if you are lucky enough to have the market move in your favor.
Risks of Leverage:
Leverage increases both profits and losses. You could lose more than you invested.
Margin calls: If you lose a trade, your broker may ask you to increase your margin or close the position at a loss.
Over-leveraging is dangerous, particularly for beginners. Even a slight price change against your position could lead to huge losses and wipe out your entire account.
Best Practices for Using Leverage in trading:
- Start small: If you are new to leverage in trading, begin with a low leverage ratio (such as 2:1 or 5 to 1) to limit your risks.
- Stop-loss orders automatically close your position if the market moves against your interests, thus limiting your losses.
- Do not over-leverage: Just because high leverage is possible, it does not mean that you should. Only risk what you are willing to lose.
- Watch Your Margin Level: Keep an eye on your margin levels to avoid margin calls or forced liquidations from your broker.
Conclusion:
Leverage in trading can be a powerful trading tool that helps you increase your profits and losses. It allows you to take on large positions in the market with less capital. However, the risk of losing a lot of money is increased if you lose the trade. It’s crucial to use leverage in trading wisely. You must manage your risk and set a stop-loss order to do this.
Remember that leverage in trading is a high-risk investment, and while it can increase profits, you should proceed with caution, particularly if this is your first time.