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What Is Leverage in Trading & Why Is It Used?
Leveraged trading is an important concept you should know about when trading assets in a financial market, whether it is Forex trading, cryptocurrency and digital assets, shares or other asset classes.
Leveraged trading helps investors gain exposure to financial markets and trading with a potential opportunity to see more significant returns but equally considerable losses.
In this article, you’ll learn all about leverage trading, leverage ratio, how to do leveraged trading and the pros and cons.
Table of Contents:
- What Is Leverage in Trading
- What Are Leverage Ratios
- What Is Margin Trading When Trading With Leverage
- How Do You Leverage Trade
- Pros and Cons of Leveraged Trading
- How to Minimise Risk When Leverage Trading
- Final Thoughts on Leveraged Trades
What Is Leverage in Trading? ➡️
Leverage is a ratio representing an investor’s exposure to a trade of an underlying asset. Using leverage means investors can control trades of higher value than the margin held. Essentially, leverage uses borrowed funds to increase trading positions on underlying assets beyond cash balance availability. To start leverage trading, you must use a brokerage account that allows you to leverage through margin trading, where the broker provides the borrowed funds.
For your trade to execute, you have to maintain an initial margin in your account to cover some of the costs of the transaction. Regardless of whether your trade makes a profit or loss on the position, you must pay back the total amount of borrowed leverage from your leverage lender. So, the amount you leverage you will be expected to pay back when the trade closes.
What Are Leverage Ratios? ⚖️
A leverage ratio is a financial measurement that shows how much capital comes from borrowed funds. The leverage ratio measures your total exposure to financial instruments compared to your margin. The leverage ratio will depend on how much leverage you need on your desired trade.
For example, suppose you start a trade worth $20,000 and have $2,000 in available funds. In that case, you are utilising a leverage of 20:2. However, if you’re new to leveraged trading, you may want to start with a 1:10 ratio, or if you’re going to play safe even further, you can choose a leverage of 1:1 depending on the starting amount.
With high leverage ratios, there is a chance of higher profits earned, but with any leveraged position, you could face a more significant loss. Typically, maximum leverage ratios in Australia are 30:1, with the lowest being 2:1.
What Is Margin Trading When Trading With Leverage? 👀️
Margin is the funds needed in your trading account to execute a trade. You must always have sufficient funds (margin) in your account to retain open positions. Margin is the amount of money needed to open trading positions.
Margin and leverage are different. Leverage is a multiple of the margin requirement (deposit). However, both terms are used interchangeably to describe accruing exposure greater than your current capital.
How Do You Leverage Trade? 📊️
You can use leverage across most markets, including Forex markets, commodities, cryptocurrency, shares and indices. You can apply leverage to any of the above financial instruments if you find a brokerage offering leverage trading.
- Create a trading plan: You should always go into investing and trading with a plan. You need to know what asset class you’re investing in, how much money you’re willing to invest, and the types of trading you want to do. With leverage trading, you should plan the leverage ratio and different brokerage offers and account for potential gains and losses.
- Open a trading account: You must open a trading account on the platform you plan to buy shares with. Consider different factors like fees, transaction types, and available leverage ratios.
- Measure risk exposure: Assess market volatility and your potential losses and earnings. Knowing all the risks of leverage trading will help you become emotionally and financially prepared for potential gains or losses.
- Choose position size: Once you’ve chosen your asset class, it’s time to choose your position size, how much you’d like to invest, the margin requirement, and the trade length.
- Start trading with leverage: Once you’ve done all of the above and have the right funds in your account, you can start leverage trading. Once you’ve begun the trades, keep an eye on them and ensure the minimum margin requirement is within your account to avoid a margin call.
Pros and Cons of Leveraged Trading
You must know all the pros and cons if you’ve not executed a leveraged trade before. With any investment, preparation is vital.
- Magnified profits: Leveraged trading magnifies your profits if you have successful trades.
- Free up capital: As you only need to reserve the margin in your trading account, it frees up the remainder of your available balance. If you didn’t use leverage, you may have to use all your funds for the trade instead of just partially.
- Access to a more significant position size: Your position sizes will be significantly larger, as when you leverage trade, you will gain access to additional funds, which means potential profits could be more significant.
- Magnified losses: Leveraged trading can increase profits but also magnify losses. Only borrow the amount you can afford to lose.
- Margin call: If you don’t have the right funds in your trading amount to cover the potential loss, your trade will be placed into a margin call. Once there is a margin call, your broker can close your positions to minimise risk.
How to Minimise Risk When Leverage Trading 🔎️
It’s no secret that leveraged trading is risky; it can be promising, but there is a chance your trade falls short. It’s not all doom and gloom; there are ways you can minimise risk when leverage trading. To help you, we’ve compiled a list of all the ways you can leverage trade with fewer worries:
- Understand leverage: Researching about leveraged trading will help you make a more informed decision when trading capital.
- Create a risk management plan: You need to create a risk management plan; these are useful for protecting capital and minimising loss.
- Apply risk management tools: There are tools you can use to help manage risk, such as stop-loss orders.
- Conduct market analysis: Whichever asset class you plan to trade in, look at the market to predict the best times for investing and see how your chosen assets are performing. If the market moves drastically (incline or decline), you may find the perfect window to start trading.
- Hold onto your head: Investing your hard-earned money can affect your emotions, especially if there are significant losses.
We will explain the steps further in the following sections, and share with you how you can minimise risk when leverage trading.
1. Understand Leverage Trading
Investing, trading, and looking into finance-related research are your best friends. You should only be investing in assets you’re confident with and using trade types you’ve done plenty of research for. Using trading methods and unfamiliar markets you know little to nothing about could set you up for a potential loss that could have been avoided.
You should be researching leverage trading as much as you can. This article is here to help, but you must do more extensive reading to prepare for your first leverage trade. The more you know about trading and the financial markets, the more familiar you will become, and you can enter trading with a sound mind and knowledge to back your actions.
2. Create a Risk Management Plan
A risk management plan can’t stop your trades from coming up short, but it can help you manage the risk and expectations involved. Assessing all that can go right and wrong will help you become more prepared for when the trade ends.
A risk management plan helps protect capital and minimise loss. Consider the following factors when assessing risks:
- Decide on the maximum percentage of your funds you want to risk.
- How to enter and exit trades.
- Where to set profit and loss limits.
- How to deal with your emotional well-being.
- A plan to help you stick to the plan.
- What to do if the market movements don’t fall in your favour.
3. Apply Risk Management Tools
Although you can’t prevent a trade from falling through, you can utilise tools so there is minimal impact if it does happen. These tools should be part of your risk management plan.
You can implement the following methods to help minimise capital loss when trading:
- Diversifying your portfolio: If an asset drops in market value, and you put all your funds into one asset, you risk losing all your capital. That’s why it is best practice to invest in various assets to protect your capital against volatile markets.
- Stop loss orders: Adding a stop loss order to your trade allows you to control the maximum amount of capital you can lose per trade. However, there may be some slippage if there is low liquidity, so you could still lose more capital.
- Limit orders: If you’re selling assets, consider limit orders. You can set a limit on the minimum and maximum selling price, and once the limit is reached, the trade will be executed. Limit orders ensure you don’t lose money on your assets. However, if you create a maximum limit order and the market value rises above it, you could miss a significant profit.
4. Conduct Market Analysis
Market analysis plays a massive part in investing. Looking at market conditions, trading volume, trends and prices can help influence your trading habits. You can see what’s currently succeeding and which assets you may want to stay away from temporarily.
Once you’ve chosen the asset class you want to leverage trade, you should keep an eye on its market performance leading up to the trade. Check for any dips in the market, search for what other traders say about it online, and generally get to know the market so you can be the best prepared for the trade. If the market moves drastically (incline or decline), you may find the perfect window to start trading.
Consider studying the following when conducting market performance analysis:
- Volume and value.
- Buying patterns.
- Customer segments.
Market performance is essential for making predictions on trades. You can find out which assets are available to trade, which position to hold and how long for. Traders can make more informed decisions if they’re familiar with financial markets.
5. Hold Onto Your Head
When it comes to investing your hard-earned money, it can affect your emotions, especially if there are significant losses. Having a plan in order and preparing for all possibilities could save you some worrying.
If you’re watching your trade decline in real-time, stick to your original plan. Making impulsive choices may further harm your capital. So, try to stay level-headed and trust in your trade. Hopefully, with the risk assessment and further research, you feel at ease when trading.
If trading is getting too much for your emotional well-being, try to take yourself away from the situation, and remember only to trade funds you can afford to lose so you don’t get into any potential debts.
Final Thoughts on Leveraged Trades 💡️
Leveraged trading is ideal for increasing your profit when trading and gaining exposure. However, as much as there is a chance of a profit, there is an equal chance of loss. It’s essential only to invest what you can lose to afford and always have a risk management plan ready before trading.
Leverage trading is ideal for increasing exposure and giving you access to funds you didn’t have immediate access to. However, remember, when borrowing funds, you will have to pay them back regardless of the results of your trades.
Frequently Asked Questions 📢️
Why Do Traders Use Leverage in Trading?
Leveraged trading can aid investors in gaining full exposure to financial markets and trading with a potential opportunity to see more significant returns but equally considerable losses. Using leverage means investors can control trades of higher value than the margin held. Leverage uses borrowed funds to increase trading positions beyond cash balance availability.
Why Is Leverage Trading Risky?
Leveraged trading is ideal for increasing your profit when trading. However, as much as there is a chance of a profit, there is an equal chance of loss. Additionally, if you don’t have the right funds in your trading amount to cover the potential losses, your trade will be placed into a margin call. A margin call enables a broker to close your positions to minimise risk.
Do You Have to Pay Back Leverage?
Regardless of whether your trade makes a profit or loss on the position, you must pay back the total amount of borrowed leverage from your leverage lender. So, the amount you leverage you will be expected to pay back when the trade closes.
Do You Need a Trading Strategy for Leveraged Trades?
You should always go into investing and trading with a plan. You need to know what asset class you’re investing in, how much money you’re willing to invest, and the types of trading you want to do. With leverage trading, you should plan the leverage ratio and different brokerage offers and account for potential gains and losses.
What Are the Drawbacks of Leverage Trading?
Like with any investing method, there are drawbacks to leverage trading. The drawbacks you may come across are as follows:
- Leveraged trading can increase profits but can also magnify losses. Only borrow the amount you can afford to lose.
- If you don’t have the right funds in your trading amount to cover the potential loss, your trade will be placed into a margin call. Once your trade is in a margin call, your broker can close your positions to minimise risk.
- Whatever funds you borrow for the trade, you must repay regardless of whether your trade succeeds.
What Is the Maximum Leverage in Australia?
The leverage ratio measures your total exposure to financial instruments compared to your margin. The leverage ratio will depend on how much leverage you need on your desired trade. With high leverage ratios, there is a change of higher profits earned, but with any leveraged position, you could face a more significant loss. Typically, maximum leverage ratios in Australia are 30:1, with the lowest being 2:1.
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