One of the most crucial ideas to comprehend while trading on financial markets like forex, share CFDs, cryptocurrency CFDs, and indices is leverage.
Not possessing the entire amount of equity required when trading conventional stocks or bonds enables traders to have total exposure in trade and possibly experience higher gains or losses.
In other words, leverage makes trading more accessible by enabling traders to trade with funds greater than their actual holdings. This works similarly to when someone borrows money from a bank to buy a property; if you can put down a portion of the whole amount, the bank will make up the difference. When used in trading, it entails your broker covering the remainder of the deal amount while you provide a portion of it.
Before delving deeper, let’s first grasp a basic understanding of the term “leverage” in trading.
What does trading leverage mean?
Leverage is a ratio that shows how exposed you are to a particular deal. Leverage allows you to manage sales worth more than the margin you already possess.
Example of leveraged trading
Example of leverage in the forex market
Let’s say your trading account has USD 1,000 in it. You discover a trading opportunity in EUR/USD and buy at the going rate (1.20). You put your take profit order at 1.21 with a stop loss at 1.1970 (30 pip below the current price) (100 pips above the market price). You get an excellent risk-to-reward ratio of 1:3.33 as a result.
The most you should risk on a single trade is 3% of your account balance, or in this example, €30. Your stop loss is worth 30 pip; therefore, if you traded a 0.10 lot (worth $10,000), your risk would be $1 per pip.
Brokers will allow you to change your leverage up or down to meet your needs; in certain situations, you may go as high as 400:1, delivering significant profits for very few investments. Theoretically, it sounds fantastic, primarily when it works, but traders must constantly remember that using leverage increases both gains and losses. Therefore, the danger rises as leverage increases.
What are the benefits of trading with leverage?
Leveraged trading has the following two primary benefits:
Improve your profits (but can also magnify losses). Leverage increases the reward from profitable deals.
Releasing capital: You may use the remaining free margin for subsequent trades because you only need to set aside a tiny amount of your total available balance for one position.
What are the drawbacks of trading using leverage?
Magnified losses: Leverage can boost your revenue, but it can also make your losses more noticeable. Therefore, it’s crucial to handle leverage responsibly.
Margin call: If you don’t have enough money in your account to cover a possible loss, your trade can be put into a “Margin Call.” If this happens, your broker may sell off your investments to lower risk for both of you.
Leverage allows traders to join and handle greater money with a little margin, which is an advantage. Naturally, this is enticing to many traders, but it’s crucial to remember that leverage and margin trading can have a double-edged effect by amplifying both gains and losses.