What Is Leverage in Trading: The Pros and Cons
For many traders and investors, leverage is considered an important and crucial benefit when trading. However, while leveraged trading has its pros, it definitely comes with its own cons.
So what does leverage mean exactly, how does leverage trading work, and what are the advantages and disadvantages of leverage? Here’s what you need to know:
What Is Leverage in Trading?
To put it simply, leverage, or margin trading, is the use of a small amount of capital to increase your trading position. That is to say, that leverage borrows funds (debt) with the hopes of boosting returns from a trade.
For example, if the leverage is 1:10, then the traders will need $1000 in order to enter and maintain a position of $10,000.
While leverage may sound like an attractive notion to some, it is important to be aware of the fact that if the market prices shift against your trade position, then leverage can potentially magnify your losses as well.
What Is the Difference Between Leverage and Margin?
Often, leverage and margin can get intertwined and the difference between the two can get lost. While these two trading techniques share a lot in common they are indeed different. In short, margin refers to the amount of money needed to open and sustain a leveraged position, whereas leverage refers to the ratio of investment one puts in the trade. In addition, usually, when the margin is bigger the leverage ratio is smaller, and vice versa.
What Are Leveraged Products?
Leveraged products refer to financial assets that allow traders to magnify their exposure to both gains and risks using a smaller amount of initial capital (margin). Leveraged products can range from Futures to stocks and options to CFDs.
Which Markets Can You Trade Using Leverage?
Traders can use leverage on a plethora of financial markets like Forex, Cryptocurrency, Indices, Stocks, and more. Therefore, there are leveraged Forex trading, leveraged indices trading, leveraged Cryptocurrency trading, and more.
Leverage Ratio Formula
To calculate the leverage ratio, you can refer to the following formula:
Leverage = [contract value/ Margin]
Benefits of Using Leverage
Potentially magnified gains: perhaps one of the most obvious advantages of leverage is the potential of magnifying one’s gains if the market prices go well with the trade.
Access to more “expensive” markets: through leverage, traders may gain access to more expensive markets using a smaller amount of initial capital.
Take advantage of volatility: while the market is known for its volatility, sometimes, it can hit a plateau, and through leverage, traders may be able to increase the chances of their profitability even at times of market quiet.
Are There Any Disadvantages of Leverage?
Leverage certainly has its own disadvantages that traders should be aware of and these are the following:
Potentially magnified losses: while leverage can magnify one’s gains, it can also potentially increase the losses in case the market moves against one’s trade.
Higher expenses: leverage can provide traders with access to more expensive markets, but is still, in itself, more expensive than other forms of trading.
Higher complexity: leveraged trading is considered more complex, at times, harder to master than other forms of trading. Hence, traders who are interested in trading with leverage should develop a nuanced understanding of how it works in order to decrease its risks and potentially benefit from it.
All in all, leverage can be a useful tool to traders if the markets go along with their position. Nonetheless, it is crucial to understand that it can be a double-edged sword that can wind up harming trading if it is not understood correctly and if the market prices shift against your predictions.