Leverage is the practice of using an amount of debt or borrowed capital to take a position in an investment, finance a project, or fund a business and using it to increase and multiply the potential return on the capital deployed. While the upside in doing this is apparent, any downsides are also enhanced and amplified.
Most commonly, trading leverage is used to describe the borrowed capital used to take larger position sizes while day trading forex, crypto, commodities, or other trading instruments.
Firms can expand their asset base to generate returns on risk capital or use it to increase potential earning. This is defined as financial leverage.
Investors can also gain exposure to leverage through companies who use debt financing to bolster shareholder earnings by using capital to invest in increased business operations and or boost a stocks value. This is more along the lines of operating leverage in which higher total fixed costs mean a higher leverage ratio.
The term highly leveraged or over leveraged refers to an investor or trader that has taken on too much debt, making their position especially risky. Typically, to secure the debt, an investor or trader must put some of their own capital up for collateral before taking a position. Potential risk and reward are then multiplied by how much leverage a trading platform allows.
Although leveraged trading carries high risk, it can also be used as part of a sound risk management strategy by putting less overall capital on the line. The use of leverage and how traders can utilize it within their overall trading plan varies greatly.
Traders often assume that leverage and margin are one and the same and use the terms interchangeably, however, this is incorrect. Margin is the value available within a margin account that can be used to apply toward leverage. Essentially, margin is what is used to create leverage trading positions.
It is helpful to always keep additional margin available within a trading account in case positions go against the trader’s plan or it could lead to a risk of capital loss or liquidation. Therefore, it is important to always pay attention to margin requirements.
Liquidation occurs only when there is no remaining available margin to cover the value of open positions. When this occurs, all positions are liquidated and any remaining limited funds are returned to the investor accounts balance.
Now that the differences between the unique types of leverage have been explained along with the differences between margin and leverage, for the rest of the guide we will only be referring to leveraged trading, the type used in forex trading, the stock market, or cryptocurrencies.
Leverage uses margin available in a margin account to increase the size of a position at the time of position open. Depending on the amount of leverage offered, the leverage ratio and how much margin required will vary by platform or even trading instrument.
Leverage lets traders put up only a small fraction of the total position required up for collateral, and the broker will supply the rest with debt capital. To provide a clear example of how leverage works, think about buying 10 BTC at a price of $10,000 each. On a spot trading platform, this would cost $100,000 plus fees. If Bitcoin’s price then rose 10%, you would earn a $10,000 return on the original investment.
With leverage, however, on a margin trading platform, the same size position would only cost $1,000 to cover a trade using a leverage ratio of 1:100. The same amount of money will be made in returns, but significantly less capital will be put at risk for a greatly amplified effect.
Be sure to always calculate the potential risk to reward to consider whether to use leveraged products or not.
The variety of leveraged products that exist are far too many to mention them all, so we will focus on the most common types of leveraged products available to traders. Forex trading is one of the most highly leveraged markets due to the relatively smaller price movements. By applying leverage here, small movements turn into large profits. Common forex leverage ratios reach as high as 1:1000.
Cryptocurrencies like Bitcoin are also among the most popularly traded assets using leverage. Due to how volatile these assets are, there is a risk of losing all capital and therefore leverage ratios typically max out at just 1:100.
CFDs for commodities, stock indices, and more make a range of leverage possible depending on the platform and trading instrument.
Elsewhere in the stock market or other markets, options contracts, futures, and other types of leveraged products exist. Leverage opportunities even exist in the bond market or through indirectly investing in companies that are highly leveraged.
The main advantages of utilizing leverage involve increasing profit margins and return on investment. By using leverage, smaller positions become much larger positions based on debt collateral. This multiplies gains by the leverage ratio for even faster capital growth.
This has a secondary impact on top of the primary effect. Using leverage also means that there is less overall capital put on the line. This in itself can be used as part of an effective risk management strategy.
It may then feel contradictory to warn that using leverage carries high risk. But this is true. Although it is a powerful tool to protect capital, in the wrong hands it can lead to a complete loss of capital. Due to this, inexperienced investors risk losing all of their money. This is also why most authorised and regulated exchanges offer leverage to only the highest level of institutional investors.
Some may consider the risk of not being able to go back to normal spot trading after experiencing leverage trading for the very first time. Knowing you can make the same amount of money with less on the line is undeniably appealing. Witnessing returns multiplied dramatically is also a thrilling experience that can cause a dopamine rush.
Using a leverage ratio of 1:100 is a great way for newer traders to get comfortable calculating their risk to reward ratio, and ensuring their positions all meet the 1% rule and risk management strategy.
The 1% rule asserts that no new trader should ever risk more than 1% of their capital at any given time or position, no matter how attractive the trade potential.
While this may seem like a slow rate, it would take 100 losing trades in a row to lose all capital, and require only half of the time to be successful to become profitable.
Using 1% on a spot exchange, however, would take ages to build capital to anything worthwhile. Taking advantage of leverage turns 1% of a $100,000 account into $100,000 in trading power instead of $1,000.
Leverage is debt capital, or borrowed capital from a broker using an account with available margin. Margin is used to apply leverage to positions based on a leverage ratio. Only a small portion of an account is used and the broker supplies the rest, adding more trading power overall.
This leverage is used by investors and traders to increase returns significantly but carries a big level of risk of capital poss.
Margin specifically is referencing the funds available within a margin account provided to apply to much larger positions using leverage.
For example, 0.01 BTC is required in margin to cover a 1 BTC position using a leverage ratio of 1:100, the most commonly found maximum leverage available for highly volatile cryptocurrencies.
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