You may have heard of the term leverage. It is a widely used word that applies to industries as varied as accounting and management consulting. It is also a term widely employed in financial circles and the online trading world. The definition is simple – leverage is any type of trading that involves borrowing your broker’s money to trade more assets than you could afford with your own money. We have written this short article to explain what leverage is and how best to use it.
What Is Leverage Trading?
As mentioned, leverage is the facility by which you can use the broker’s money to buy assets of which the value is much higher than what you can afford on your own. Normally, leverage works closely with margin. Margin is when the broker asks you to put up some of your own money as collateral. After all, the broker’s money is being used to enter a risky financial transaction, and the broker must protect its interests by making sure that if you lose, as happens very often with new traders, it can recover some of the loss.
With leverage, you only put down a percentage of the capital in your account, with the broker topping it up with funds of its own. Depending on the type of trader you are, leverage trading becomes more attractive. If you are a scalper, a trader who enters hundreds of trades per day to make small profits from selling stocks, cryptos or FOREX, then leverage is exactly what you need to amplify your trading efforts.
Take scalping cryptos, for example. Scalpers must find the optimal relationship between the length of their exposure and the amount of leverage they employ. Some scalpers trade in intervals as brief as one minute at a time, as they try to take advantage of the high volatility in the crypto market. As you can imagine, not much profit can be generated from a one-minute trade, but, with leverage as high as 1:200, earnings can be multiplied several times over.
By contrast, if you are a trader who works with much slower forms of trading, such as swing trading, you are investing more funds with each trader and are going for a larger swing (profit) over a longer period of time, meaning that you do not need leverage quite as much as do your scalping counterparts.
How Does Leverage Trading Work?
Leverage works hand in hand with margin, as we have said. Margin is simply collateral that your broker can call in when it sees you are making heavy losses. Different brokers ask for different amounts of margin. Some can ask you to put up 50% of any amount you want them to match. Other brokers in less well-regulated regions can ask you to put up only a small percentage of the amount they will loan you; but, in that case, they rarely offer you negative-balance protection, meaning you could trade on leverage until your account goes into the negative.
Let us illustrate how leverage works. Perhaps you want to invest $100 in a stock you think is performing well and has a high upside. You are expecting an earnings report for the stock to be released in a matter of days and you are certain the report will show positive growth, which will result in the share price climbing. Your investment of $100 is a small amount, but that is all you can afford, even given the fact the broker topped up your initial funds with additional margin.
You are so sure of your strategy that you feel comfortable leveraging your trade by 1:20, meaning you have $2,000 worth of stock. The earnings report is released and your predictions come true, the share price climbs 5%. This means you have earned $100 if you choose to exit the trade at that point by selling the stock. Without leverage, you would only have made $5, which seems hardly worth the trouble. You can see how leverage helps traders like you. Note that this example does not account for fees.
Pros and Cons of Leverage Trading
As with any type of trading, leverage trading comes with many pros and cons.
Bigger profits. With leverage as high as 1:200 in some jurisdictions, there is no doubt you can make a lot of money.
You don’t need a lot of capital to start. This is the whole point of leverage. You can start trading with a small outlay.
You can diversify. Diversification is one of the most important things you can do in your trading career to manage your risk. With a bigger pool of capital, you can trade many different assets.
Bigger losses. Leverage trading is risky. It is no wonder that many regulators cap the amount of leverage brokers can offer you. Losses can be sudden, and massive.
More risk. The more you put on the line, the more you stand to lose. Brokers want you to be successful so you can be a repeat customer. Nobody wants traders to succumb to excessive risk.
It can be hard to master. There will inevitably be bumps in the road as you learn leverage trading. Suffering heavy losses can be disheartening, but you just have to persevere.
The Bottom Line
Leverage is an excellent way to grow your profits. However, it is a risky exercise that carries with it the possibility that you could lose big if you do not use leverage with discretion. You should always try your strategies on a demo account first to see how you would have performed in the real world.
Adrian Ashley is a seasoned business and finance writer. With a corporate career spanning over 20 years, he has developed deep experience in such diverse areas as investing, business, finance, technology and macroeconomics.