Leverage is a Danger

Leverage - Danger for New Traders

Tue Nov 09 2021 16:51
Investing with leverage increases your buying power and potential returns. But even with increased purchase power, leverage is still a danger, especially if you are a new trader. 

It increases the risk for loss to possibly unlimited loss from bad investments. 

Trading using leverage expands your financial resources. It gives you an opportunity to purchase more than you can afford and make returns with borrowed funds. However, leverage has its share of challenges. This post discusses the danger of leverage to new traders in detail.

What is leverage in trading?

Leverage results from utilizing borrowed capital as your funding source as you invest to expand your asset base and make returns on risk capital.

In simple terms, leverage is an investment strategy where one uses borrowed funds specifically, the use of different financial assets or borrowed capital, to increase possible returns of an investment. It can also refer to the debt amount a company uses to finance assets. 

In trading, leveraging arises when a trader uses borrowed capital to invest in security, stock or currency. This concept is common in forex trading. Investors borrow money from brokers so they can trade in larger positions in security or currency. 

As a result, the leverage magnifies returns from favourable movements in a security’s or currency’s exchange rate. Though it’s a good investment strategy, leveraging can also magnify losses. 

Both experienced and beginner traders should learn how to manage leverages as well as risk management strategies that help mitigate losses.

Pros and cons of using leverage

Leverage is a two-edged sword. As much as it can help magnify returns, it can magnify losses.
Advantages of using Leverage
  • Magnified profits: you put an amount of money and multiply it by your leverage. If your trade is successful, you’ve made a lot of money.
  • Access to high-value securities: leverage trading is not attractive anymore when you think of increased losses. And as a beginner trader, you don’t want to keep tracking short-term trades at once. So, when should you consider it? The best time is when eyeing a higher-valued stock such as Tesla. You can use this strategy to take a bigger position which you couldn’t with just your cash account. Though it's still risky, think of the odds aligning in your favour. It's all about risk tolerance and a trading plan.

Disadvantages of using leverage

  • More fees: borrowing funds come with fees and a margin rate. Options can cost you more such that winning trades aren’t profitable. Commissions and fees should not stop one from making a trade. If the trade is good, it should be worth it. However, when the fees are too much, they may negate your profits or turn the trade into a loss.
  • Magnified losses: a rational investor considers risk all the time. You can get into very dangerous situations with leverage since it makes it easy to get overextended, leading to bigger losses.

Picking the right leverage level

Every trader should review available regulations and leverage before making a trade. The simplest rules are:
  • Ensure you maintain low levels when leveraging
  • Using trailing stops to protect capital and avoid losing money
  • Limit capital to at least 1% of the total trading capital on every position taken
Traders, especially new traders, should choose the level of leveraging they are comfortable with. Calculating the leverage should be the first step. As you do this, compare with your available cash and top up the balance with credit.

If you are not a risk-taker or simply conservative or still learning trade currencies, go for low leveraging, for example, 5:1 or 10:1.

New traders should avoid brokers offering high leverage. Though it's tempting, it's equally dangerous, especially if you are new to this kind of investment. You can opt for limit stops or trailing. They provide you with reliable ways to reduce losses when your trade goes in the wrong direction.

By using trailing, beginner traders can keep learning trade currencies while limiting losses in case a trade fails. The stops are essential as they help decrease trading emotions and allow traders to pull themselves from their trading desks with fewer emotions.

Trading CFDs with leverage and margin

CFD trading can either be leveraged or trading on a margin. Meaning, an investor’s deposit is geared or magnified by their broker. It allows you to control larger amounts of underlying securities, which unlevered deposits would not allow. That is the importance of leverage as an investment strategy.

There are different types of leverages in trading. They include capital, operating, working capital and financial leverages. Most of these relate more to firms. The common credit in trading is the capital credit, as traders look for capital to invest in leveraging.

Risks associated with high leveraging

We have seen that leveraging involves borrowing money to invest in financial assets. In trading, capital is acquired from a broker. While traders can borrow huge amounts of capital on their initial margin requirements, they can make more money from successful trades.

Initially, brokers would offer high ratios up to 400:1. This means with $250 as your deposit; you can control approximately $100,000 in currency in any global market. 

Later in 2010, regulations were set to limit the ratios set by brokers. The ratios were limited to 50:1, which is still high. This means with the same deposit of $250; you can control about $12500 in currency.

So, should you select a low credit level as a new currency trader? Let’s say a 5:1 or just roll the dice and go for a 50:1? Before answering, it’s wise to take a look at examples that show the amount of money you can make or lose in different leverages.

1. An example with maximum leveraging

Assuming trader one has $10000 cash and goes for 50:1 leveraging. This means he can trade close to $500000, which is five standard lots in forex.

The trade sizes in forex are a mini lot, 10000 units, micro-lot, 1000 units and standard lot, 100000 units. They measure movements in pips and a one-pip movement is ten units in a standard lot change.

Assuming this trader bought five standard lots, each one-pip movement will be $50. If the trade by bad luck goes against the investor by 50 pips, he loses 50pips x $50, which is $2500, a 25% of the initial $10000.

2. Using less leveraging

Moving to trader two, instead of going for a 50:1 ratio, the trader chooses 5:1. Assuming the trader has $10000 cash, he can trade $50000 of currency. Each mini lot goes for $10000 and each pip is a $1 change. Since this trader has five mini lots, every pip is a $5 change.

If the trade is against him by 50 pips, he loses 50 pips x $5, which is $250, a 2.5% of the whole position.

Making money with leveraging is possible, but it requires more expertise. Some experienced traders would never go for leveraging no matter how tempting it looks, and they still make huge profits. Similarly, other traders take advantage of leveraging to make attractive profits in their trading.

Whether to go for leveraging is a tough decision. It depends on several factors, the first one being your risk tolerance and expertise in the field. It’s a good strategy but very risky. And if you are a new trader, it becomes riskier. You may find yourself in huge losses that may limit you from further trading.

Learn more about leveraging and start getting FREE trading signals by signing up at Xosignals.
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