The Concept of Leverage and Why it is Important to Traders – Introduction
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 large 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 leverage 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 leverage 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.
What is Leverage in Forex and CFD Trading?
The concept of leveraged explained above is also applied in the financial markets. Companies like Day Trade The World 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 leverage 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 leverage 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 leverage was during the Brexit vote and the 2016 US election.
The leverage 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 currently trading at $1,200. If the trader uses a 100:1 leverage, they can buy gold futures worth $100,000.
The size of leverage a trader uses can make or break their accounts. Most experienced risk-averse traders prefer using a low amount of leverage 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 overleveraged can present you to significant risks. Being underleveraged on the other hand can minimize your earning potential.
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. 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 leverage 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 leverage to the broker, leaving your account with $5,000. If you had a higher leverage ratio, your loss would have been bigger.
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 leverage to use. Experienced professionals who have excellent knowledge on risk management can use high leverage 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.