When you trade with leverage, you can make a lot of money, but there are also a lot of risks. That’s why it’s important to know because if you don’t, trading becomes a risky game with a small chance of success. So let’s take a look at how Leverage Trading Leverage works and what its pros and cons are.
What is Leverage Trading
One of the most powerful tools traders can use is leverage.
With Leverage Trading, you can make trades that are much bigger than what you’re really risking. This means that you will make more money, but you will also lose more than when you don’t use leverage.
In other words, Leverage Trading is a tool that will make your trades more profitable or less profitable.
HOW DOES THE LEVER WORK?
Leverage trading, also called margin trading, is trading with money that you have borrowed.
When a trader opens a position, he or she makes a small deposit (called a “margin”), such as 10% of the total order. The broker pays for the rest of the order.
If the trade makes money, the trader gets both the margin and the profit back. If they don’t, the margin will be used to cover the losses.
If the loss is more than the margin, the broker will tell the trader to put more money into the account or end the trade. If the trader doesn’t answer, the broker will close the trade for him or her so that the trader doesn’t lose money.
EXAMPLE OF A Leverage Trading
1. Don’t borrow money to trade
Let’s say you are betting on how much the Czech crown will be worth in US dollars. You think the dollar will get stronger, so you spend $1,000 on it. You paid a total of 22,000 crowns because the price to buy was 22 crowns. The exchange rate will go up to CZK 22.50 in a few days, so you sell the dollars and get CZK 22,500. The profit is $500, which is a little more than 2% of what was put in.
2. Leveraged Trade
Now, let’s use tenfold Leverage Trading in the same situation (1:10). Your buying power is 10 times bigger, so even though you only put in $1,000 (22,000 CZK), the trade volume is 10 times bigger (10,000 dollars or 220,000 CZK).
Optimistic scenario
At the rate of CZK 22.50 per dollar, you are selling. The broker will give you back the margin (your $1,000) and the profit, which will be 5,000 crowns (225,000 CZK – 220,000 CZK). If we don’t count fees, the return is 22.7%, which is 10 times higher than when trading without Leverage Trading.
A pessimistic scenario
At the rate of CZK 21.50 per dollar, you are selling. So the dollar has gotten weaker and you’ve lost CZK 5,000. (CZK 220,000 – CZK 215,000). You will only get back 17,000 CZK of the 22,000 CZK you put in at the start. This is a loss of 22.7%. Again, we do not figure out how much it costs to simplify.
If the dollar’s value drops to 19.80 crowns, you will lose all of the margins (CZK 22,000) you put into the trade. The value of the dollars that were bought would go down from CZK 220,000 to CZK 198,000. If the price went down even more, the loss would be bigger than the initial investment.
SIZE OF LEVERAGE
The size of the leverage is given by the ratio of the margin to the total order. For example, the Leverage Trading will be 1:100 if the order size is $10,000 and the required margin is $100. The opposite marking, 100:1, is also used a lot, but it means the same thing.
How much financial Leverage Trading is used is based on the following:
- Brokerage company: The maximum leverage is set by the broker.
- Instrument: The most leverage is found in those whose prices don’t change much (for example, forex). The lowest leverage is used to trade things like cryptocurrencies and stocks that change a lot.
- Experience as a Trader: Professional traders have more leverage than regular people.
- Regulation in Europe: Since 2018, the European Securities and Markets Commission (ESMA) has limited the amount of leverage that retail traders can use.
ESMA limits:
1:30 for major currency pairs
1:20 for minor currency pairs, gold, and major indices
1:10 for non-gold commodities and minor stock indices
1:5 for stocks
1:2 for cryptocurrencies
WHEN AND WHERE IS LEVERAGE USED?
When you trade forex and contracts for difference, you will use leverage (CFDs). On the margin, you can also trade stocks, cryptocurrencies, and derivatives of stocks, such as options or futures.
Short-term trades that are made on a hunch use leverage. Leverage isn’t a good choice for long-term investments because it costs more and doesn’t let prices change as much.
Risks of Leverage Trading
With financial leverage, you can get good returns without having to have a lot of money or wait for the market to move a lot. But there are two sides to every coin, and if you underestimate the Leverage Trading, it will quickly turn against you.
1. LEVERAGE ALSO INCREASES LOSSES
The use of financial Leverage Trading can boost both profits and losses. Since leverage works the same both ways, a hundred times leverage (1:100) means that both profits and losses are multiplied by 100.
But in order to make money, you have to be able to handle the changes in the market. And this is exactly why the lever is cruel in this way.
2. THE BIGGER THE LEVER, THE SMALLER THE SWINGS YOU CAN WITHSTAND
Even when markets are calm and don’t move, stock prices are always changing. Forex tends to have small changes, but Bitcoin, for example, has daily changes that are measured in units of percent. So expect to lose money on every trade, even if it’s only for a short time.
It’s easy to trade without Leverage Trading:
How much does the price of the instrument change, and how much will the trader make or lose as a result? The price of the instrument would have to go to zero for you to lose everything you put into it. But it seems unlikely that gold or shares of well-known companies would be given away for free. This is just not likely to happen.
But when you trade with Leverage Trading, everything is different.
Every change in price is multiplied, so you can quickly lose your whole investment. Even the whole capital sometimes. For example, if you trade cryptocurrencies with Leverage Trading of 1:100 and the market moves against your position by 1%, you will lose your entire investment (100 x 1% = 100%). A 2% drop in the price of the cryptocurrency would mean a 200% loss, and this could keep going on forever.
The more you use Leverage Trading, the less you can handle swings. If there isn’t enough free money in the account, even a small change in price combined with high Leverage Trading can make the whole account go back to zero.’
3. MERCHANTS CAN GET INTO DEBT
When a trade goes wrong, the loss can be more than the amount invested and, in the worst case, even more than the total amount of capital. Most of the time, a stop loss or a margin call will stop this from happening. However, if the price changes quickly, both of these can fail.
If your account balance drops below zero, two things can happen:
- If you are not a professional trader and trade forex or CFDs with a regulated broker, the broker will forgive your debt. Any broker with a European license will protect your account from going into the red (this is called “negative balance protection”).
- Professional traders and clients of brokers who don’t protect them from negative balances must pay back the debts they’ve made.
An example from practice
When the Swiss National Bank stopped making changes to the CHF without warning in January 2015, the markets were shocked. In response, the Swiss franc rose 20% against the euro, which caused many forex traders to lose a lot of money (and brokers).
Here, you can read about a Czech businessman who owed the Saxo Bank broker almost a million dollars.
We have to stress that the ESMA rules didn’t come out until 3 years later. Before that, trades were done with very high Leverage Trading (usually 1:100 or more) and accounts weren’t required to be protected against debt.
How to tame Leverage Trading
Have you ever thought about why foreign exchange is so popular? Why do traders focus on currency pairs when they can also trade stocks, indices, or even commodities?
The lever is the reason.
Traders want to make the most money possible, and currency pairs offer the most leverage and, therefore, the best chance of making money. But this is a terrible idea!
Eighty to ninety percent of traders who use Leverage Trading end up losing money. If you want to get serious about trading, the first thing you need to do is learn how to cut your losses as much as possible. What leverage isn’t supposed to do?
Leverage Trading can help you trade, but you must follow 3 important rules:
- Money management: The most you should lose in a single transaction is 2% of your total capital. The size of each trade and the size of the lever must be changed to fit this. Don’t forget about the changes in the market that you have to deal with.
- Don’t let your feelings get in the way: for each trade, you need to decide at what loss or what gain the trade is closed. Use stop-loss and take-profit instructions, which will automatically close the position, for the best results.
- Discipline: Rules don’t mean anything if you don’t follow them.
Terms that may come in handy
FREE MONEY
Your trading account has funds that you can use at any time (ie uninvested money).
ENTRY MARGIN
The initial Margin is the amount you need to trade for the first time.
The size of the entry margin is given as a percentage of the total amount of the order. If the Leverage Trading is 1:10, then the entry margin is 10% of the total volume of the position.
MAINTENANCE MARGIN
Maintenance Margin is the minimum amount a trader must keep in his account to keep his Leverage Trading positions open. The maintenance margin works like a savings account from which losses can be covered if things go wrong.
The price of the underlying asset determines how big the maintenance margin is. This means it will change while the trade is going on.
MARGIN CHALLENGE
Margin Call: a call to get more money. If the trader’s free capital falls below the required level, the broker gives this to the trader (i.e. below the maintenance margin level). You can add more money to your account or close one of your trades to get more free capital. This will also lower the maintenance margin requirement. If the trader doesn’t answer, the trade may be closed automatically.
Bottom Line
We won’t tell ourselves a lie. Most traders can’t deal with a lot of leverage. That’s just how things are.
Financial leverage wasn’t made for traders, but for brokerage firms. After all, the most leverage is offered by brokers who don’t have licenses and aren’t afraid to use aggressive telemarketing or fake ads that promise millions of dollars in profits.
Steve Cohen is a businessman and hedge fund manager from the United States.
Leverage, not being diversified, and not having enough cash on hand are three things that can bring you down.
For new traders, we do not recommend leveraged trading at all! This tool is for traders with a lot of experience who know what leverage is and how to use it.
You may also like, CFD Trading: Advantages and disadvantages
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