What is Leverage?
Leverage is a form of an operational facility provided to an investor by a broker that enables traders to take positions larger than the required amount of capital. By just paying down a portion of the total position value, the investor’s market exposure is increased. In other words, using leverage in trading entails using funds through a form of credit.
How does leverage work?
Let’s say a trader decides they need more money to trade while having PHP10,000 in their account. They might then decide to use the leverage that a broker offers. They could have invested PHP100,000 if they opted to apply a 1:10 leverage (10,000 X 10). The broker will essentially lend you the remaining funds to enable you to start the position after taking a specific amount as margin, which varies depending on the type of financial instrument.
Getting into detail about the Concept of Leverage
Let’s assume that your trading account has PHP10,000 in it. You choose to invest this amount in shares at a cost of PHP50. As the price rises during the day, you once more close the bet when it reaches PHP60. Let’s now analyze what would happen if we trade with and without leverage.
Without using it, the price has increased by PHP10, and 100 shares would cost PHP5000. The value of these 100 shares has increased by PHP10. In this scenario, your overall profit is PHP6,000 or 20%.
Now, let’s say that you choose to apply a 1:10 leverage to your investment. Currently, shares cost PHP100,000 to purchase. A trade on 1000 shares is available. The value of these shares has increased by PHP10. In this scenario, your overall profit is PHP10,000 or 200%.
As you can see, applying leverage would allow you to benefit more in this situation. However, keep in mind that the same thing may have occurred in the other direction. When using leverage, your loss would have been greater if the price had dropped.
Advantages and Disadvantages
Leverage allows traders to join and handle larger money with a little margin, which is a benefit. This is enticing to many traders, but it’s crucial to keep in mind that it can have a double-edged effect by amplifying both gains and losses. You can use the remaining free margin for subsequent trades because you only need to set aside a small amount of your total available balance for one position.
Leverage can boost your earnings, but it can also multiply your losses. Therefore, it’s essential to handle leverage responsibly and consider the possible consequences of a losing trade. Furthermore, your trade may be put into “Margin Call” if you don’t have enough money in your account to cover a potential loss. If this occurs, your broker can close your holdings to reduce the risk for both of you.
How do I minimize my Risk with Leverage Trading?
Although using leverage can result in substantial returns, it’s wise to remember that there is always a chance of losing money. Having a strong risk management strategy in place, such as defining the maximum percentage of your account balance you wish to risk per trade, is one way to limit risk.
To limit the greatest amount you can lose on a deal, use stop-loss orders. However, keep in mind that stop-loss orders are not guaranteed, and you can encounter some slippage during periods of low liquidity.
By using a trading plan and keeping a trading record, you can keep your emotions in check. Trading using leverage can be alluring because it gives traders the ability to control a much larger stake than they would otherwise have.
Now You Know!
It’s important to monitor and manage one’s position continually. An investor must first determine whether the cost of debt is less than the potential return before acquiring a leveraged position. If an investor doesn’t have enough capital to cover any potential losses, they shouldn’t ever acquire a leveraged position.
Lastly, it is advisable to refrain from employing excessive leverage while first learning to trade. Leverage should only be used once you have a firm grasp of how to profit from trading. You can greatly boost your revenues if you use this effective tool correctly.
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