The Concept of Leverage and Why it is Important to Traders

The meaning of leverage is very important to people who want to make a living from the financial markets. To starters, the concept can sound confusing especially when it is compared to margin.

Leverage is simply a credit that brokers give to their traders to enable them open llarge trades, which are often more profitable. On the other hand, margin refers to the borrowed funds a trader uses to trade in financial instruments.

Examples of Leverage

On a macro level, leverage is used by countries and companies. A good example of it is that of an entrepreneur who starts a business with $5 million. To build his plant and stock the company, the entrepreneur could go to a bank and take a loan of $20 million.

The entrepreneur will use part of the revenues from the company to pay the lenders. If the business is unable to pay back the money, the creditor can force the company to liquidate.

Countries too use leverage to finance their developments. A country like the United States has a GDP of about $18.5 trillion but it has a total debt of more than $21.2 trillion. Because of its overall credit rating, lenders are always pleased to extend credit in form of treasury bonds.

Another example for how this is used is the old story of the Hunt Brothers. The brothers – Nelson and Herbert – inherited a fortune when their father died in the 1970s. To grow their wealth, the brothers started buying silver and silver futures.

By 1980, they owned more than 75 million ounces of silver. Their demand for silver made the price to soar from less than $10 to more than $50 a ounce.

To finance the silver purchases, the brothers turned to banks, which extended to them credit worth more than $1 billion. Then, in 1980, COMEX changed the rules of silver ownership leading the price to fall to below $10. The two brothers later declared bankruptcy.

→ Silver, all you need to know

What is leverage in forex and cfd trading?

The concept explained above is also applied in the financial markets. Companies like DTTW™ want their customers to be profitable. So, they offer different leverage ratios, which help the traders to trade more assets and maximize the opportunities presented by the market. The ratios offered ranges from 5:1 to 500:1.

The size of the leverages these companies offers also depends on the assets. For example, the maximum amount for cryptocurrencies – which are often very volatile – is usually lower than that of currencies like EUR/USD.

They also reduce the overall leverage for certain assets when they expect a major market-moving news.

They do this to minimize the risks in case of a major shock in the markets. For example, some highly leveraged brokers were forced to near bankruptcy in January 2015 when the Swiss National Bank (SNB) unpegged the Swiss franc from the euro.

Another major market events when brokers reduced the amount of money borrowed was during the Brexit vote and the 2016 US election.

The amount offered by the brokers helps traders trade more and even trade in assets that they would not afford without leverage.

For example, a trader with a $1,000 account would find it very difficult to trade gold futures, which are for example traded at $1,200. If the trader uses a 100:1 ratio, they can buy gold futures worth $100,000.

Markets where you can trade using leverage

You can trade using leverage in multiple assets like stocks, currencies, cryptocurrencies, indices, and commodities. You just need to find a broker who offers leverage and you can take advantage of it.

Leverage ratio calculation

Leverage is calculated using a very simple formula: L = A/E

In this case, L is leverage, A is the asset amount while E is the margin account.

Importance of leverage in trading

To begin with, this reduces the amount of capital that a trader needs to have to open a trade. Some people think of trading as a venture meant solely for big money investors.

Fortunately, leverage allows an individual with as little as $100 to get a piece of the pie. With a reasonable ratio, you can deal in amounts that initially seemed unattainable.

Furthermore, this is a helpful tool in increasing profits. When the price of a financial instrument makes a slight change on the upside, the trader gets a substantial profit depending on the ratio.

For instance, if an asset’s price shifts by 1 pip, a leverage of 100:1 will bring in higher returns compared to 50:1. However, it is important to note that the probable losses heighten as the ratio increases.

Basically, the size a trader uses can make or break their accounts.

The right size

Most experienced risk-averse traders prefer using a low amount because of the risks of being over-leveraged. New and inexperienced traders on the other hand tend to go for the highest leverage offered by the brokers.

The risk of this is that they suffer more losses when their trades go in the wrong direction.

In the example above, the Hunt brothers were not forced to file for bankruptcy because the price of silver fell. They were forced into bankruptcy because of the debts they had taken. In other words, the total value of silver they had was less than the total value of their debt.

Therefore, if you are a new trader, you should take the concept of leverage very seriously. This is because being too much exposed can present you to significant risks. Being underleveraged on the other hand can minimize your earning potential.

The Meaning

To get a better understanding on the application of leverage in trading, consider the different scenarios in the table below. In this example, we will assume that the trader in question has $500 in his trading account.

 

No leverage

1:10 leverage ratio

1:50 leverage ratio

Initial capital

$500

$500

$500

Asset’s price shifts by +10%

Profit of $50

Profit of $500

Profit of $2500

Asset’s price shifts by -10%

Loss of $50

Loss of $500

Loss of $2500

As seen in the table, leverage acts as a loan that increases one’s trading capital. A higher ratio will equate to more returns if the trade favors you. However, the reverse is also true. If the price moves against your prediction, a higher ratio will equate to hefty losses.

As a novice trader, do not be quick to jump onto a high leverage. Your account can be swept out clean in a matter of milliseconds in the event of an unpredicted price direction. To avoid such a scenario, use a low leverage ratio, slowly accumulate your returns and watch as you attain your trading goals.

Besides, take time to understand the market and practice via a demo account. Trading is all about strategy. Unlike the popular misconception, it does not use the gambling approach.

Another practical example

Assume you are a CFD trader who specializes on American equities and the stock of company A is currently at $100. Your trading account has $10,000 and you are using a leverage ratio of 2:1.

After your analysis, you believe that the stock will rise to $125 after the company releases earnings (read here for some tips about earning seasons). So, you decide to use all your funds to buy the stock. In total, you will buy 200 shares. Without the leverage, the maximum number of shares would be 100.

If your thesis works out and the stock moves to $125, the value of your trade will be $25,000 (125X200). After returning the $10,000 leverage to the broker, your profit will be $5,000. If you had used a higher ratio for the trade, your profit would have been much higher.

On the other hand, if after the earnings release the price of the stock fell by 25% to $75 and you decide to exit, the value of your account will be $15,000. You then return the $10,000 borrowed to the broker, leaving your account with $5,000. If you had a higher ratio, your loss would have been bigger.

Pros and cons of leverage

As mentioned above, this is an important concept in day trading but it has its pros and cons. Let us look at some of the top benefits of using leverage in day trading

Pros

  • Better profits - Using leverage allows you to make more money than when trading without it.
  • Multiple assets - This strategy can allow you to open multiple trades at the same time. For example, if you have a $1,000 account, and a stock is trading at $20, it means that you can only buy 50 shares. If you had more money available, it is possible to open trades of more assets.
  • Buy unaffordable assets - Another benefit is that this allows you to buy expensive and often unaffordable assets.

Cons

  • Bigger losses - If your broker does not have negative balance protection, it means that you can lose more money than your trading balance.
  • Margin call - A margin call is when the broker asks you to add money to your account when a trade makes significant losses.
  • No shareholder rights - When you use leverage to buy a stock CFD, you don’t have the rights that ordinary shareholders have.

Risk management in leveraging

Therefore, since leverage is a double-edged sword, it is important that you learn how to manage its risk. It is recommended that new traders should start trading with a small amount. While this will not make them a lot of money, it will help them to sustain their accounts. Then, they should add to their starting amount as they become more experienced.

Still, every trader should avoid being too much exposed. A good example of this is Bill Hwang who lost $20 billion in less than a week due to leverage.

» Related: Risk management strategies

Bottom Line

For forex and CFD traders, the importance of leverage cannot be understated. Traders should take time to assess their risk appetite before deciding on the size of money to borrow.

Experienced professionals who have excellent knowledge on risk management can use high ratios to maximize their profits. For traders starting out, it is recommended to use a lower leverage ratio.

While the profits will be less, the trader will be comfortable knowing that they are not exposed to much risks.

External Useful Resources

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