One of the most potent weapons in a trader’s or investor’s toolbox for increasing returns is leverage. But before we get into what leveraged trading is, let me offer a Warren Buffett quotation that many stock market traders are sure to be aware of: “When you combine ignorance and leverage, you get some very intriguing results.”
This phrase resonates because leveraged trading can drastically enhance your returns in the right hands, but it can also have a devastating effect on your cash flow and mentality when in the wrong hands.
In the stock market, it is a well-known fact that the larger the gain you want, the higher the dangers. And leveraged trading, which is employed in the Foreign Exchange Market, or Forex market, is an extremely risky technique to use if you don’t have the necessary expertise and experience to deal with the highs and lows that come with this type of trading.
Leverage Trading
The ratio applied to the margin amount to determine the size of a trade is known as leverage. Understanding margin and leverage, as well as the differences between the two, can be difficult at times. It’s crucial to understand that margin is the amount of money needed to open a trade.
Leverage of 10:1 means that the required margin to open and maintain a position is one-tenth of the transaction amount. So, a trader would need £1,000 to enter a $10,000 deal. The margin amount is the proportion of the total trading cost that must be paid to open the position. As an example, if a trader wished to conduct a £10,000 trade on a financial asset with leverage of 10:1, the required margin would be £1,000.
Leverage may appear to be a very enticing part of trading because winnings can be greatly increased. However, leverage is a double-edged sword, and it’s vital to realize that losses can be readily multiplied as well.
All traders should be aware of the dangers associated with leveraged trading. Because of excessive leverage, many traders find their margin wiped out extremely quickly. When practising margin trading, novice traders should be extremely cautious. It is preferable to be more cautious and apply less leverage. With less leverage, traders are less likely to lose all of their money if they make a mistake.
How Does Leverage Trading Work?
It is recommended that a trader begin trading on leverage with leverage that is lower than their maximum leverage permit. This allows traders to keep their positions open for the full amount, even if they are losing money.
Those who trade short-term price swings are more prone to use leveraged trading. It would be significantly less ideal for long-term investors, such as those investing for years or even decades. In this case, a ‘buy and hold strategy might be more appropriate.
Example Of Leverage In Stock Trading
Let’s imagine a trader has a maximum leverage of 5:1 and uses that leverage on a $10,000 account to open a position on Apple shares. When compared to if they had purchased the assets outright without leveraging their $10,000 starting capital, the trader now has a position size with an asset worth of $50,000, giving them trading exposure to 5 times as many shares. To keep this leveraged position in Apple stock, the trader’s account value must stay above the 50 percent maintenance margin requirement, or $5,000 in this case.
Leverage Ratios In The Financial Markets
Leverage Currency Trading
The buying and selling of foreign currencies on a global market are known as forex trading. Forex leverage ratios begin at roughly 30:1 when compared to other markets, implying that there is a huge potential for profit or loss, depending on how you look at it. This, however, might vary depending on the sort of trader, whether retail or professional, as professional traders can use up to 500:1 leverage.
Leveraged Stock Trading
Share trading is another market with a relatively low leverage ratio. For significant international stocks like Apple, Tesla, and Amazon, leverage ratios start at 5:1 or a 20% margin rate. This is true for the lowest tier, which ranges from 0 to 13,600 units. When you open a position for more than this amount, the margin rate rises, lowering the leverage ratio you can trade with.
Leverage For Indices
Indices reflect a group of assets from a specific exchange’s overall price performance. The FTSE 100, S& P 500, and Dow Jones 30 are all popularly traded indices. Indices have relatively modest margin rates, resulting in leverage ratios of around 20:1.
Cryptocurrency Leverage Trading
The cryptocurrencies bitcoin, ethereum, and litecoin are all well-known around the world. Because cryptocurrencies are extremely volatile and can decrease at any time, investors should exercise caution when utilizing leverage in their trading strategy, as this could result in severe losses.
Leverage Ratio Formula
Understanding how to determine the leverage ratio is crucial when applying leverage. The leverage ratio formula is simple to remember and often used:
L = A / E
where L stands for leverage, E for margin (equity), and A for the asset.
As a result, the leverage ratio is calculated by dividing the asset value by the margin value.
Risks Of Leverage
When discussing leverage, the most crucial thing to remember is the danger involved. Any sort of trading involves risk; however, leverage can magnify both gains and losses. Traders should exercise caution when deciding how much leverage to employ. Before trading, the leverage ratio should be set. If you have a string of profitable transactions, it is highly tempting to trade in a higher size than what was originally determined.
Doubling your risk on a one-time basis could benefit a trader if that one-time trade goes well. However, if it is done incorrectly, a trader may suffer a much higher loss than typical. You should plan out your trading strategy ahead of time to help limit trading risks.
When deciding how much leverage to apply to a portfolio, two aspects should be considered: how much risk to take every trade and how much risk to take per day. Examining this in terms of percentages simplifies things. To begin, a trader must decide how much risk they are willing to take each day. This entails determining how much money you are willing to lose. For example, this may be anything between 1% and 2%. If a trader’s maximum daily risk is set at 2%, it would take 50 days of terrible losing transactions in a row to wipe out their capital, which is very unlikely to occur.
A trader should also decide how many deals per day they wish to make. This could be a fixed number or a limit. For example, a trader may decide that no more than three deals will be made per day, regardless of the market. In each situation, the trader might multiply this amount by the percentage they are willing to risk per day.
Leverage Risk Management
A stop loss is a prominent risk-management measure to consider when trading with leverage. You can limit your losses if your chosen market moves unfavourably by adding a stop-loss order to your position. A trader, for example, might set a limit that they don’t want to go above, implying that your interest in the instrument will be sold at that price. Basic stop losses, on the other hand, are vulnerable to market gapping and slippage. Guaranteed stop losses work in the same way as normal stop orders, with the exception that investors can pay a modest fee to ensure that a trade is closed at the exact price stated. In this manner, regardless of market volatility, if you used a large level of leverage in the trade, you will have a lower likelihood of multiplying your losses.
Conclusion
Remember, leveraged trading can drastically enhance your returns in the right hands, but it can also have a devastating effect on your cash flow and mentality when in the wrong hands.
To enhance your returns in the right hand, click here.
