Leverage Trading: The Pros and Cons
By Dale Gillham |
Leveraging is one of the most powerful tools traders and investors have in their toolbox to increase returns. But before we discuss what leveraged trading is, let me share a quote from Warren Buffett that is most likely familiar to many traders in the stock market: “When you combine ignorance and leverage, you get some pretty interesting results.”
The reason this quote resonates is because in the right hands, leveraged trading can dramatically increase your returns but in the wrong hands, it can have a devastating effect not only on your cash flow but your psychology as well.
It is a well-known fact in the stock market that the higher the reward you seek, the higher the risks associated with it. And leveraged trading, which is used in the Foreign Exchange Market or Forex market, as it is known and Contracts for Difference (CFDs), is a very risky strategy to apply without the right knowledge and experience required to handle the highs and lows that are prevalent with this form of trading.
What is leveraged trading?
Leveraged trading, which is also known as margin trading, margin finance or trading on margin, allows you to open a trading position with a broker using a small amount of capital in order to take a much larger position in the market.
For example, in some countries, if you have a $1,000, you can leverage your trading position up to 100 times or more. So, if you leveraged at 100 to 1, you would be exposing yourself to managing a position of $100,000 in the market.
When trading on margin, the margin itself is typically expressed as a percentage of the total position size. For example, forex brokers will say they require 1 per cent, 0.5 per cent or 0.25 per cent, which allows you to calculate the maximum leverage you will be exposing yourself to when opening a trade. So if you put up $1,000 and decide to open a leveraged position on 0.5 per cent, your exposure in the market would be $200,000.
That said, ASIC issued an intervention order in 2020 that reduced the maximum leveraging ratios available to retail clients when trading CFDs to provide better consumer protections although the limits are dependent on the type of instrument being traded.
That aside, you don’t need to be a genius to see that this type of trading can potentially break the bank very quickly if you lack the required knowledge to manage the risk.
Leveraged trading has become an extremely attractive option for traders and investors given that it allows them to fast track their potential returns. But, unfortunately, it is those individuals with very little capital and knowledge who are attracted to highly leveraged markets because they believe they will become much wealthier in a shorter period of time than from any other method of trading. In reality, however, this is far from the truth.
Let me say, if you are serious about wanting to succeed in the stock market over the longer term, you must follow the number one trading rule that applies in any market. The higher the risk, the greater the level of knowledge and experience required to manage the risk, which becomes even more important when trading leveraged products in a volatile market.
So let’s consider the pros and cons of including leveraged trading as part of your overall investment strategy.
The pros of leveraged trading
As I have already alluded to, one of the advantages of leveraged trading is that it provides you with access to additional funds because you are borrowing money from the broker to gain more exposure to the market than you otherwise would.
As you are exposed to a larger position in the market, you have the opportunity to magnify your returns. For example, let’s say you decide to enter into a forex currency trade on the AUD/USD dollar because you believe the Australian dollar will fall in value against the US dollar. Now let’s assume you decide to trade $500 on margin at 0.5 per cent, your exposure in the market would be $100,000. So you are now controlling a $100,000 trade using only $500 of your own money.
Now let’s assume you were right in your assumption about the Australian dollar falling, so your $100,000 is now worth $102,000. Therefore, if you decide to exit your position, you will have made $2,000 on an investment (before costs) using $500 of your own money. That’s a gain of 400 per cent.
Obviously, you can see that the use of leveraging will dramatically increase your profitability as a trader.
However, there are always two sides to a story and you need to consider the risks, as leveraged trading can backfire on you pretty quickly if you get your analysis wrong.
The cons of leveraged trading
Just as leveraging can magnify your profits, it can also magnify your losses.
Let’s continue with the previous scenario but let’s say that instead of the Australian dollar falling, it rises against the US dollar. So you now find that your open position is sitting at $98,000 or a loss of $2,000 on your initial exposure of $100,000, which means you are down 400 per cent.
So, not only have you lost your initial capital of $500 but you are now required to cough up an additional $1,500, as the broker will have made a margin call on your account to cover the losses. In fact, Forex brokers will require you to maintain a certain amount in your brokerage account to cover margin calls in the event a trade goes against you.
You also need to be aware that when you open a Forex or CFD trading account, you will be required to sign documents that state the broker has the right to recover any losses from you if they exceed the money in your account. And I am aware of some pretty horrific stories where individuals have lost substantial amounts when trading these markets that have cost them their savings and sometimes their house.
It is for this reason, why it is vital that you acquire the right knowledge and experience to learn to trade stocks before you decide to trade these markets because as I have mentioned many times before, your education will cost you one way or another.
The reality of leveraged trading
Do you know that 90 per cent of individuals who trade these markets end up broke or, at best, break even? Furthermore, the lifespan of most traders who trade highly leveraged markets is measured in weeks and months not years. This is why there is so much marketing hype with the promise of riches around leveraged trading because the brokers need to continue to entice new people to take up the challenge.
Imagine having a business plan where you could predict that every 9 in 10 traders will lose most, if not all, of the money they place in their brokering account. It would make for a very nice business model. Well this is the reality of leveraged trading. If you don’t have the knowledge or skill to manage yourself in these markets, you will ultimately lose and the brokers know this
I know some of you won’t hear this message until you actually experience it but the statistics don’t lie. We all know there is no such thing as “get rich quick”, yet so many are attracted by this hype. But what if you could “get rich slowly”? Well that is what I am proposing when I tell you to get a proper trading education because it will repay you in spades. It will also reduce the risk of trading leveraged products if you choose to do this because you will be armed with the knowledge to know how to trade in all market conditions.
In fact, one of the strategies I teach my clients as part of my four golden rules to investing in shares is to never invest all of your money in trading short-term, highly leveraged markets. Instead, you should allocate 90 per cent into a medium to long term portfolio and invest the remaining 10 per cent in leveraged markets. The trick with this strategy is to have the 10 per cent allocated to trading short term, highly leveraged markets achieve equal or better returns when compared to the other 90 per cent.
This strategy is not only very achievable, but more importantly, very repeatable when you have gained the required knowledge and skill to trade highly leveraged markets. I outline this strategy in detail in my latest book, Accelerate Your Wealth, It’s Your Money, Your Choice, which is available to purchase online and at all good book stores.
I can categorically say, if you follow my advice, you can become one of the 10 per cent that consistently makes money in the markets.
Invest in yourself
As I mentioned previously, if you are serious about your success in the stock market, than I encourage you to equip yourself with the tools to confidently trade in any market condition; we’ve got the books and trading courses to advance your knowledge and place you in an advantageous position. To speak to a member of our team, call 1300 858 272 or Email and they will provide you with any further information you need.
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