What Is Leverage Trading? How Does It Work?
In trading, you can stress less by putting down less initial capital when doing leverage trading. However, you first need to know what you are doing before going down the leverage trading road. Combining ignorance and leverage can result in huge losses.
Knowing what leverage trading is, how it works, and how to apply the strategy will protect you from making losses. Thankfully, this guide explores all the basics you need to know about leverage trading. That will help you get started.
What Is Leverage In Trading?
Leverage trading increases the investor’s power. It enables the investor to use borrowed capital to invest more. With leverage, the investor can open trading positions that are greater than their initial capital.
When using leverage to trade, the investor’s idea is to buy more assets expecting that the returns will be more than what they borrowed to enable them to repay the loan and earn profits.
However, the same way leverage gives you the potential of gaining greater profits; it also exposes you to potential losses. Losses happen primarily to people who use the trading tool without the proper knowledge or research.
Important Terms To Know When Leverage Trading
- Buying power is the total amount of money you have, together with the leverage, to buy stock or securities.
- Margin is one of the pillars of leverage trading. This is the amount your broker requires to compensate themselves if losses happen when the trade becomes unfavourable.
- Margin Calls occur in leverage trading, as there is a minimum required account balance that your account should not fall below. The broker will give you a margin call to warn you that you are exposed to a risk level when this happens.
You are required to add money to your account to move your account balance to the required amount. The other alternative is to close your trading position and suffer losses.
- Coverage is the ratio between the net balance in your trading account to the leverage amount.
- Open position means that you have an operating trade that you have not closed with an opposing trade.
- Close position is the value of your investment at the time you closed the position. For example, if you opened a position with $40 and closed it at $50, the close position is $50, and your profit is $10.
- Stop-Loss Helps limit the risk exposure by automatically closing the trading position if some parameters do not work out well. For example, if the trade is meagre, the stop-loss triggers and completes the transaction to prevent losses.
How Trading Leverage Works
The primary way to understand how leverage trading works is by thinking of it as a loan. You trade on leverage through a broker. If you have a certain amount of money that is not enough to buy securities, the broker finances you to purchase the securities.
Any difference between the trade’s opening price and the closing price is settled in your account balance. When you gain profits from the sale of the assets, you pay the broker from your earnings.
On the contrary, if you make losses during trading, the broker takes out what is left in your account to compensate themselves. Leverage trading is not accessible to all traders because the broker considers some factors before loaning a trader.
Is There A Difference Between Leverage And Margin?
Leverage and margin have different meanings. Leverage is the loan you get from a broker to boost your stock purchasing power. The trader takes this loan, hoping they will sell it at a higher price and make profits.
Margin is the amount of capital your account needs to have to maintain leverage. The margin could have an almost similar meaning as a down payment of a loan. If the money in your account falls below the agreed margin level, you could get a margin call.
Tips To Help You When Trading With Leverage
Trading with leverage has both pros and cons. Although you might not be planning to use leverage when trading, it is essential to know some basic tips that will help you.
-
Always Draw A Trading Plan
This does not apply with leverage trading only, but with any trading. A trading plan helps you to choose a strategy that suits you. Research the pros and cons of each technique. Identify your entries, exits, and stops, and always ensure you stick to the plan.
Again, knowing your goals and risks is a trading plan for any trade, but it is more critical when leverage trading. Have complete knowledge of the risks you are exposed to.
Although some people are usually lucky in trade, you should never rely on luck. Knowing your risks helps you see them coming, and you’ll have better strategies on how to stop and protect yourself from losses.
-
Have An Open Mind About Losses
In trading, the possible outcomes are only two; you can either make profits or accrue losses. Have a set amount you are willing to lose to losses, but do all you can to protect yourself from the losses.
-
Consider The Fees And Commissions
Brokers charge fees and commissions throughout the trading period. Once you are aware of this, you will prepare your finances beforehand. Ensure you know all the additional costs you will incur in your trading period.
-
Always Ensure The Health Of Your Account Is Secure
The goal of trading is to make profits and not losses. This also applies to leverage trading, in which you need to make more significant profits to keep your margins right. Self-discipline with your trading strategies will help you to keep your account healthy.
Pros And Cons Of Leverage Trading
You can gain huge profits with leverage trading. The more money you invest, the larger the profits you are likely to achieve. However, you need to formulate a good trading strategy to maintain these profits.
The opposite could also happen. You buy huge stocks with leverage trading, hoping to make huge profits, but you could incur significant losses if the trade is unfavourable. Leverage trading is two-way traffic, so you should be prepared for both.
When you get into leverage trading, the broker loans you some money to boost your purchasing power. You can get more stocks with more money that also increases your chance of making more profits.
You can also take more prominent trading positions with leverage. To protect yourself from the risks, stick to your trading strategy. Know when to make stops and when to close your trade.
However, getting more stocks with leverage trading attracts more fees. You could even end up making fewer profits because of the borrow fees and the margin rate you have to maintain.
However, never let commissions and other fees stop you from trading. As a good trader, always prepare yourself for these extra expenses because your profits make a huge difference, no matter how small they are.
Final Words
Investors who are looking for huge returns have the advantages of different trading tools. However, any trading tool has its pros and cons. Leverage trading is one of the powerful tools for trading, but do your research before signing up for the trading tool.