What is leverage? How do you use it in trading? What are its advantages and disadvantages? To find out the answers to all these questions, keep reading our article!
Leverage is an essential concept in trading. If you learn how to use it wisely, it can help you tremendously. Simultaneously, if you're not cautious enough, poor leverage choices can break your trades. This is the reason why leverage is a double-edged sword.
Before explaining some of its advantages and disadvantages, we need to stop for a minute and detail how leverage works.
Leverage – what’s this all about?
In simple words, leverage refers to controlling a more substantial sum of money with a smaller investment of your own and borrowed from a broker.
Leverage is expressed in ratios. Let’s look at a quick example for you to better understand how this works. To open a 10k position, you might be asked to use $1,000 of your own money, and the rest $9,000 can be “covered” by your broker. In this particular case, your leverage will be 10:1.
Another term you need to accustom yourself with here is margin – the amount of money you need to have available for you to open a position. From the previous example, the $1,000 deposit is the required “margin” you had to use from your own pocket to access leverage.
There are a couple of other trading terms concerning leverage: invested capital and capital at risk. The first one refers to the total amount value of the trading operation. The second one defines the amount of funds in your account, which is a potential risk in the trading operation.
Advantages of using leverage
As long as you use leverage with care, it can turn into a powerful trading tool. First of all, it can magnify your returns by providing you with extra capital on your trades. With the margin support, leveraged positions can multiply your winnings on successful trades. Be careful, though: they can increase your risks when your trades go awry.
Leveraged trading allows you to take advantage of both markets that are in bearish and bullish territory. For a better understanding of these two concepts, take a look at this article.
Additionally, trading with leverage allows you to diversify your portfolio. How’s that possible? Straightforward enough. Using leverage, you can free up some of your funds and open multiple positions, gaining exposure to different markets and asset classes if you want to.
At CAPEX.com, you can trade CFDs with leverage on more than 2.100 financial instruments! This type of derivative trading enables you to use margin for a higher exposure (together with increased risks) to many different types of assets! Check out our collection of tradeable instruments in our markets page!
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Disadvantages of using leverage
If you consider trading with leverage, you should be aware of several potential shortcomings. The most significant one we already mentioned: it can enlarge your risks. To counter this, experts recommend not to think about your trades in terms of margin alone. Instead, consider analyzing them at their full value.
Then, you will be required to keep positions open overnight, which comes with additional costs. Different brokers charge various taxes for covering these costs.
Finally, you might be asked to pay extra money to keep your position open – the so-called margin call tax. This is different from the funding charges required for maintaining the trades open overnight.
How to use leverage in trading the financial markets?
There is no universal strategy for trading the markets with leverage. A good starting approach could be learning to manage the actual debt you undertake to the best of your abilities, according to sources such as investopedia.com. In short, we’re referring to accessing different leverage levels offered by brokers.
To do so, you need to familiarize yourself with the financial instruments you trade and predict the possible direction they might take in the future. Learning to make investment decisions based on the cost of debt, the level of the leverage, and your risk aversion is mandatory.
Using stop loss and take profit orders can also help you if the price movements take the opposite direction from what you thought. We will address these market orders in our upcoming featured article. Just make sure you stay in touch with the featured articles section if you don’t want to miss it!
Sources: Investopedia.com, babypips.com, thebalance.com.
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