Leverage trading is an essential part of financial markets as any trading requires funds. When a trader is investing in the market, their major concern is funding; some may have high earnings to manage while others won’t be able to bring in more money.
This is where the facility of leverage trading comes to the rescue; however, it has its risks. First, traders can go through the article to understand the term and associated factors. Then, they’ll analyze leverage trading and how it works for maximum profit earning.
What is Leverage Trading?
The word belongs to the financial world, where traders highly rely on the leverage ratio for their investments.
In simple terms, leverage, meaning in finance, is borrowed money. The investors or traders borrow a certain amount to invest in an asset or market. For example, in forex or stock trading, traders borrow money from their brokers to open high market positions.
Consequently, to open trade positions and support the investments, traders rely on their financial institutions or brokers for the funds, termed leveraged trading.
How does Leverage Work?
In the basic sense, Leveraged trading is to borrow money, and it works differently for the market a trader selects to invest in. We have taken forex market and stock market examples to understand it from a wide perspective.
Traders with these analyses of the markets can know how leverage works with market trading and helps in realizing the profit potential.
Leverage in the stock market is to take funds from the broker or increase the number of shares involved in the trade open. When a trader is aware of what leverage is and the risks involved, they can properly use it to trade.
However, as the risk of leveraged trading is high in any market, traders need to be careful. In the stock market, traders can use different ways given below to apply leverage:
Margin trading is the money borrowed from a broker to buy shares, where other security or shares in the brokerage account is kept as collateral.
For example, a trader wants to invest in a Johnson company trading at $60 per share price. The trader has $12,000 in a brokerage account, so the trader purchases the shares of the company with the funds available in the account.
The trader can afford 200 shares of the company. But, if the stock trader decides to use margin and borrows $10,000 from the broker, the trader can buy 367 shares. Hence, the gain or loss is increased by 167.
If the price of the shares increases, the market trader will have profit, but if the price reduces, the trader has to face a double loss.
The same goes with the forex market when a trader borrows funds to buy currency pairs and trade.
Similar way, when a trader wants to trade stocks or currency pairs with ETFs, they can use the following way of trading with leverage.
ETFs are based on the performance of the index they are traded. Therefore, these trading instruments try to impact the assets and their performance in the market compared to market moves.
A trader can buy the shares using ETFs and go for leverage trading to increase their market position. The same goes with forex trading, where traders can buy the currency pair with ETFs through leveraged trading.
Options with the stock or forex trading could be traded using leverage. When a trader uses options in the stock market, they can trade in 100 shares of the underlying asset. The trader gets control of 100 shares, that too, at less price than the actual market cost of buying.
So, the trader would be able to profit from the leverage, as options will get great changes in the value of the security traded.
For example, a trader decides to use their call option with ZZZ company shares. However, the trader finds that the shares will lose their value in the future and sells the call option with an exercise cost of $50.
The trader can sell the option if the price drops or still has the option of buying if the price remains above $50.
In the same manner, forex traders can use the call and put options to trade on high leverage and earn profits.
Risks of Leverage
Leverage is said to be double-edged as high leverage ratios are a sign of profit and loss. When a trader goes for maximum leverage, they enlarge the potential of their profits along with loss.
This is because the risk involved with leverage is high and could impact the trade. If a trader is not alert to the investment, they might face high risk and end up losing their funds and more money.
Margin Risk and Margin Calls
We know that leveraged trading amplifies the loss of trade, and when one goes with margin trading, the purchasing power is doubled.
Thus, the chances of loss also increase with exposure to gains. For example, suppose a trader invests in stocks; here, they end up with a loss of 20% of the value. Hence, the trader will have more than 40% overall loss, including the margin money used.
In addition, traders have another risk of margin call associated with it. The broker providing leverage can initiate a margin call.
A margin call is used when a trader’s account value declines below a set value compared to the money borrowed. The broker in margin calls asks for a deposit of additional funds as they want to ensure the trader pays them if they go bankrupt.
Another significant risk of leveraged trading is the unlimited loss that traders face. Financial markets are highly volatile, and the use of leverage ratio increases the potential of losing money rapidly.
The derivatives like options have infinite risks as the value of the underlying market rises or decreases. There’s no limit to the change in the price of the assets, and when a trader invests, they may have high chances of risks.
A trader trading CFDs can also encounter such risks when the underlying asset’s price reduces in the market. Therefore, traders should analyze the market first before they invest their funds.
Be it stock or forex, the financial market traders have to be fully knowledgeable to use leverage.
Leverage not for long term
Many traders use leverage to invest in financial assets, but they are hardly aware that they cannot rely on it for a long period.
Short-term traders can have leveraged positions in the market, but traders with long-term trading styles must manage trading capital to make profits.
Advantages and Disadvantages of Leverage
Now that we know what leverage is and how it works, we have the pros and cons that traders can look at. These are useful as they give a glimpse of what leveraged trading brings to traders.
Leverage offers traders high market profits as they use the funds to invest in markets. Conversely, borrowing money from the broker reduces the fraction of money invested by the trader and receives double profits.
In trade, the profits are calculated on the open position, and the margin multiplies the returns on trade.
Using leverage means accessing markets with more capital and having funds available for other investments. As a result, traders can increase the chances of investing in the market using the opportunities present.
Traders can speculate in financial markets using leverage products. They can consider the price movements of the assets and earn profits from the fall and rise of the prices.
Leveraged trading is available to clients 24 hours; they can monitor their investments and make other trades using leverage whenever they want. However, it may vary with the markets.
Every coin has its bad side, and the same goes with leverage trading. Here, we have the cons that traders need to be careful from:
The use of leverage or margin trading increases the loss as well. When using it for borrowing money, a trader magnifies the risk of loss. Therefore, it is advised that traders use the leverage ratio appropriately.
Stock market traders do not have shareholder privilege when trading leverage. The traders have to give up their ownership right on the asset to trade.
The margin call is the additional deposit of funds that brokers require to ensure debt conditions. This is when a trader has incurred a loss and does not have sufficient funds to keep the position open.
Leverage Trading Account
A leverage trading account is simple to open with a broker. Traders have to follow the process given, and they can access the leverage ratio facility.
The initial step is to open an account with a reputed broker that has various services and tools. Once the broker is selected, commission, fees, and spread charges are analyzed with the leverage ratio offered.
Traders can then provide the required information, get themselves verified, and can deposit funds.
After this, the following step is to use the leverage ratio provided. For example, some brokers have 1:100 leverage, or others may have a maximum leverage of 1:500, depending on their policies.
By applying leverage, traders have a leverage trading account. As a result, they can trade in assets with borrowed funds and make profits.
A trader can even go for a demo account with Investby to practice and understand the use of leverage before going live.
Trading in financial places requires information on various aspects that play an important role in making markets. Leverage is one such trading style that traders can use to make high profits in most markets.
Although, the high risk of these services makes them difficult for one to use. The article defines all its aspects of informed trading. Traders can go through it to enhance their knowledge and make potential profits from the investments.