Leverage has no shortage of uses in the financial world, and it can be a confusing term sometimes. Leverage broadly means borrowing capital or taking loans to enhance the financial position of a specific entity or individual. Enterprises use leverage to scale their operations by borrowing funds from potential lenders. Banks, for example, look at the leverage ratio, among other financial metrics, before approving a loan for a specific company.
The leverage ratio in this instance is the total liabilities or debt to the total shareholders’ equity. A high leverage ratio above a certain threshold signifies that the company is highly leveraged or indebted and it, therefore, may not meet its long-term debt obligations.
Leverage as a tarding strategy
Leveraged trading is borrowing money from exchanges or brokers to trade a specific asset, such as a stock, or a digital commodity such as bitcoin. Similar to the lever used to increase the power to move a large stone, leverage can help the trader boosts the power of his initial trading position through borrowing. More on this later.
The relationship between Leverage and Margin
Traders can use leverage by opening a margin account to trade on margin. Margin trading is a form of leverage; it simply means depositing a minimum amount of funds as collateral to borrow more funds against that collateral. The minimum amount required by the law is called the minimum margin, and the amount of initial capital deposited is called the initial margin.
Now, let’s assume you have $1000 deposited in your margin account that meets the minimum margin requirements. This amount will be your initial margin, and your broker may allow you to borrow up to 100X your initial margin. As a result, your $1000 turns into $100,000. In this instance, you used 100x leverage, which allowed you to borrow 100X your initial margin, and your leverage ratio would be 1:100.
Your initial margin rate would be 1%, calculated by dividing 1/100. If you multiple 1% with the total available funds for trading ($1000 +$90,000 you borrowed, totaling $100,000), this would equal $1000, your initial margin. So, here your initial margin was presented as a percentage of the total funds.
So the leverage ratio in trading is a ratio of the initial margin or capital to the total funds available for trading. If this ratio is 1 to 500 (1:500), then the broker provides a loan 500 times the size of the investor’s deposit or initial margin.
Traders can also use leverage with other financial instruments such as futures and options. In the future market, traders can take long and short positions to bet against the price movement of an asset and can apply leverage to take more risk and possibly maximize their gains.
The pros and cons of using leverage
Leverage is a double-edged sword as it can both magnify gains and losses. It allows traders to access more capital and place bets that exceed their financial capacity, increasing their trading size and profits, respectively.
However, the high potential returns are directly proportional to the same high risks. Leveraged traders also tend to perceive loans as their own money and focus more on the size of the trade rather than the management and preservation of the initial capital.
Consider the advantages and disadvantages of leverage using the example below:
Let’s say a trader has $500 in his account and decides to buy shares worth $100 each. Without using a loan, he can purchase only 5 shares. He simply does not have enough money for more. But if he uses a broker’s loan of 1:100, he can afford to buy 100 times more shares, that is, 500 shares.
If the trade goes in his favor, then the value of the shares will increase. Let’s say it has increased by $1 – then this will mean that when selling, the trader will receive an income of $1 from each share. It is easy to calculate that without the use of borrowed funds, the trader’s income would be only $ 5, but with 100x leverage, his income becomes $ 500 (100x$5).
But the situation can also be reversed. If the trade goes against him and the value of the shares falls by $1, then without a loan the loss will be $5 – $1 per share, and with the use of margin funds the loss will be $500, and the trader will lose his entire deposit – his initial deposit.
leverage is a risky trading strategy, but it also can be rewarding when used appropriately. Leverage trading is not for novice traders. Experienced traders use leverage in specific situations with risk management tools to cut their losses short. The novice trader should never cause leverage without assessing the risk and prophase should only use a low leverage ratio such as 1:2 or 1:10.
How to use leverage correctly
Leverage is a financial instrument that, with the right approach, allows you to increase your position size and gain high profits even on small deposits. To properly use this tool, follow these simple guidelines:
- Invest in education: learn best practices, risk management, technical analysis, trading strategies, and trading psychology.
- Focus on the preservation of your capital and manage your risk accordingly. So think about the risk before the reward.
- Avoid using high leverage such as 50 and 100X unless you’re a professional trader.
- Never use leverage on all your available money for trading.
- Consider the cost of trading such as commissions, bid/ask spread, and interest charged on leveraged or borrowed funds.
- Use leverage for short term trades to take advanatge of opportunistic trades.