Leverage

Leverage

Leverage is a powerful tool that greatly enhances a trader’s ability to profit from financial markets. However, it’s important for traders to understand how it works and use it responsibly to avoid excessive risk and potential losses. Stocks, indices, forex, commodities, and exchange-traded funds (ETFs) are just a few examples of financial markets where leverage can be used. 

What is leverage? 

Leverage is a term that refers to the trading of financial instruments with borrowed funds. In the trading world, leverage is a crucial tool that allows traders to maximize potential profits while minimizing the capital required to enter a position. Essentially, leverage allows traders to control larger positions with smaller amounts of capital.  

It’s important to note that while leverage can increase potential profits, it also increases potential losses. This is because traders borrow funds to enter a position, and any losses incurred will be magnified by the leverage used. As such, it’s crucial for traders to use leverage  

Understanding leverage 

Instead of directly holding the underlying assets when you trade, you speculate on their price swings to earn a profit. When you use leverage, your broker will put up most of the capital, and you will only need to contribute a small deposit to establish a larger position. 

For instance, opening a position with a broker to trade stocks using leverage would entail borrowing most of the position’s value from that broker, depending on the leverage ratio. No fees will apply regardless of the leverage you use, whether 5x or 20x your initial deposit. 

Trading using leverage is quite alluring because winnings can be massively increased. But leverage has a flip side, and it’s crucial to remember that losses can be doubled rapidly. 

Advantages and disadvantages of leverage 

While leverage can offer significant advantages, it also comes with certain risks and disadvantages. 

• One of the main advantages of leverage in trading is the ability to generate higher returns. Financial leverage increases the impact of each dollar you invest. With leverage, traders can earn larger profits than they could with their capital alone.  

• Additionally, leverage can provide greater flexibility in trading, allowing traders to take positions in a wider variety of assets and markets. 

However, leverage also comes with substantial risks.  

• One major disadvantage of leverage is the potential for significant losses. As leverage amplifies the size of a position, even a small decline in the value of an asset can result in substantial losses. Additionally, leverage can increase the risk of margin calls, which require traders to deposit additional funds to cover losses. 
• Another potential disadvantage of leverage in trading is its psychological impact on traders. When using leverage, traders may be more likely to take on excessive risk and make impulsive decisions. This can lead to emotional trading, which is detrimental to long-term success. 

Leverage can be a powerful tool for traders seeking higher returns and taking advantage of market opportunities. However, it is necessary to consider the risks and disadvantages of using leverage, including the potential for significant losses and the psychological impact of trading with borrowed funds. To successfully use leverage in trading, it is essential to have a well-defined trading plan and risk management strategy in place. 

Calculating leverage 

To calculate leverage, traders must first determine their margin requirement. This is the percentage of the total position that must be deposited as collateral to open a trade. For example, if a trader wants to enter a position worth US$10,000 and the margin requirement is 5%, they must deposit US$500 to open the trade.  

Once the margin requirement is determined, traders can calculate their maximum leverage by dividing the total position size by the margin requirement. In the above example, the maximum leverage would be 20:1 (or 5% margin requirement divided into the US$10,000 position size).  

Example of leverage 

For example, assume a trader wants to buy US$10,000 worth of a particular share. In that case, they may only need to put up US$1,000 of their own funds if their broker offers a leverage ratio of 10:1. This means that the broker is effectively lending the trader the remaining US$9,000 to make the trade.  

While leverage can be useful for experienced traders, it carries significant risks. If the trade goes against the trader, they could lose more than their initial investment, leading to substantial losses. Therefore, traders must use leverage wisely and cautiously to avoid undue risks. 

Frequently Asked Questions