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 not only has a devastating effect on your cash flow but your psychology as well.
It is a well-known fact in the stock market that the higher the reward, the higher the risks associated with it. Unfortunately, leverage trading is a very risky strategy to apply without the right knowledge and experience to handle the highs and lows that are prevalent with this form of trading.
That's why in this comprehensive guide we're going to cover the basics of leverage trading, including how it works, the role of leveraging, and the importance of understanding the potential risks and rewards involved. As you gain a better understanding of this trading method, you'll be able to decide if this approach is a suitable investment strategy for you.
What is leverage trading?
Leverage trading, also known as margin trading or trading on margin, is a powerful strategy that allows traders to control larger positions by using a smaller amount of capital. The strategy can be applied across various markets including Forex, indices, stocks, commodities and ETFs. While leverage trading has the potential to magnify both gains and losses, it provides traders with an opportunity to earn higher returns using a smaller initial investment.
Leverage trading involves borrowing funds from a broker to increase your position size, which can result in more exposure to market movements and potential profits. However, it's important to understand that leveraging also increases the risks associated with trading, which is why you must implement solid risk management strategies and have a thorough understanding of how leverage trading works.
How leveraging increases your buying power
Leverage is typically expressed as a ratio, such as 2:1, 10:1, or even higher, depending on the asset class and the broker’s policies. A 10:1 leverage means that for every $1 of the trader's funds, they can borrow $9 from the broker, effectively increasing their buying power.
If you put up $1,000 and decide to open a leveraged position that is trading 10:1, you can borrow $9,000 from the broker, which means your exposure in the market would be $10,000. As you can see, you don’t need to be a genius to understand that this type of trading can potentially break the bank very quickly if you lack the required knowledge to manage the risk.
Is leverage trading profitable?
Leverage trading has become extremely popular with traders who like to capitalise on small price movements, such as stocks, forex, commodities, and cryptocurrencies. But, unfortunately, it is those individuals with very little money or knowledge who are attracted to these markets because they believe they'll become much wealthier in a shorter period than from any other method of trading. But this is far from the truth.
While it can increase your potential profits, it can also lead to substantial losses, as you could wipe out your entire account balance if the market moves against you. Therefore, it's essential to use leverage trading wisely, with a full understanding of the risks involved.
Let me say, that if you're serious about wanting to succeed over the longer term, you need to follow my number one trading rule, which applies in all markets. The higher the risk, the greater the level of knowledge and experience required to manage the risk. This becomes even more important when trading leveraged products in a volatile market.
To understand how leverage trading works, let's look at an example.
How leverage trading works: A practical example
Let's say you have $1,000 in your trading account and you want to trade a stock that is currently priced at $20 per share. Without leverage, you could purchase 50 shares ($1,000 / $20), giving you a total investment of $1,000.
Now, let's assume you want to use leverage. Your broker offers a leverage ratio of 10:1, meaning for every $1 of your funds, you can borrow $9 from the broker. This means your $1,000 can effectively control a position worth $10,000, which means you have borrowed $9,000 from the broker.
Using the 10:1 leverage, you can now purchase 500 shares of the stock ($10,000 / $20), instead of just 50 shares without leverage.
Let's look at what happens if the share price rises by 10%.
Without leverage: Your 50 shares increase in value to $22 per share. Your total investment is now worth $1,100 ($22 * 50), resulting in a profit of $100 ($1,100 - $1,000).
With leverage: Your 500 shares increase in value to $22 per share. Your total investment is now worth $11,000 ($22 * 500). However, you must repay the borrowed $9,000 to the broker, leaving you with $2,000. This results in a profit of $1,000 ($2,000 - $1,000 from your initial investment).
Now let’s consider what happens if the share price falls by 10%.
Without leverage: Your 50 shares decrease in value to $18 per share. Your total investment is now worth $900 ($18 * 50), resulting in a loss of $100 ($900 - $1,000).
With leverage: Your 500 shares decrease in value to $18 per share. Your total investment is now worth $9,000 ($18 * 500). After repaying the borrowed $9,000 to the broker, you are left with nothing, resulting in a complete loss of your initial $1,000.
While this example illustrates how leveraged trading can increase your profits, it also demonstrates how it can have a devastating impact on your portfolio, particularly if you choose to take on higher leveraging. As such, while it does offer the potential for higher returns, it also comes with significant risks. Therefore, as I alluded to earlier, it's important to approach leveraged trading with caution and an understanding of the outcomes.
The pros of leveraged trading
When it comes to leverage trading, there are several benefits, including:
1. Access to larger positions
Because you are accessing additional funds from your broker, your position sizes will be significantly larger than your initial capital, which has the potential to create higher profits.
2. Potential for higher returns
As we demonstrated above, larger position sizes can also result in higher returns compared to trading without leverage.
3. Capital efficiency
Using leverage allows you to maximise the use of your capital, as you can maintain a smaller cash balance in your trading account while still gaining access to larger positions, which frees up funds for other opportunities.
Remember, accessing larger position sizes comes with significant risks, which can be detrimental if you get your analysis wrong.
The cons of leveraged trading
Leverage trading can also lead to substantial losses if the market moves against you, including:
1. Increased losses
Even small market movements in the opposite direction can increase your losses, which in some cases can wipe out your entire account balance.
2. Margin calls and liquidation
In leverage trading, you're required to maintain a certain amount of equity (initial margin) in your account to cover potential losses. If the market moves against you and your account falls below the required margin, you will face what is referred to as margin call. In this instance, you either need to deposit additional funds or close some or all of your positions to meet the margin requirements. If you don't do this, the broker may liquidate your positions, which could result in significant losses.
3. Interest charges on borrowed funds
As you are borrowing funds from your broker, this will attract interest charges, which accumulate over time, depending on how long the position is open. Of course, these charges will reduce your overall profit or add to your losses.
While leverage trading is attractive, many traders open large trading positions without consideration for the significant risks they are taking. As a consequence, they trade outside their comfort level for fear of missing out believing the next trade will go in their favour.
5. Limited risk management
This brings me to one of the biggest issues with leverage trading and that is most traders overlook the importance of risk management, which leads to devastating consequences. If you decide you must trade these markets, you must practice good money management.
6. Faster-paced trading
Leveraged trading is about using short-term strategies in a fast-paced trading environment, which can be stressful and demanding. This often leads to impulsive decision-making, emotional trading, and a higher chance of making costly mistakes.
To manage the potential losses you will inevitably experience in leverage trading, you need to ensure you use solid risk management strategies, such as stop-losses and continually monitor your positions. You also need to ensure you only ever use leverage if you have the required knowledge and experience.
In my experience, you are far better off learning how to trade stocks before you decide to trade leveraged markets because your education will cost you one way or another.
Tips for managing the risks in leverage trading
As I have previously mentioned, leverage trading comes with its inherent risks, but if you implement several risk management strategies, you can minimise your potential losses. So, let’s consider how you would manage the risks.
1. Start with a conservative leverage ratio
If you are new to leverage trading or uncertain about market conditions, use a conservative leverage ratio. This will limit your potential losses while allowing you to gain experience.
2. Use stop losses
Stop losses are an essential risk management tool that allows you to close out your position if the market reaches a predetermined price level. By setting a stop loss, you can limit your losses and better manage your risk exposure.
3. Monitor your positions
You need to ensure you regularly monitor your open positions and be aware of any movements in the market that may impact your investments. This allows you to better manage your risk exposure.
4. Manage your emotions
Emotional decision-making can lead to poor choices and heightened risks. As such, you must develop a disciplined trading plan, apply your risk management strategies, and avoid making impulsive decisions based on fear or greed.
5. Educate yourself
This is a must if you want to succeed long-term. Without the right knowledge and experience to apply your analysis and manage your risk, it can feel like you are riding a rollercoaster. That's why gaining an education on how to trade Forex and CFDs will ensure you have a much higher success rate with your trades.
6. Adjust your position sizes
If the market is volatile, it's important to adjust your position size so you don't take on any unnecessary risks.
7. Have a clear exit strategy
Develop a clear exit strategy for your trades, including profit targets and stop-loss levels. Knowing when to exit a position can help to lock in profits and minimise losses.
8. Practice with a demo account
Before you decide to trade with leverage, consider using a demo account to practice with and familiarise yourself with the broker's trading platform. This helps to gain experience and confidence without risking your actual capital.
By following these tips, you can better manage your risk and increase your chances of success.
Choosing the right broker for leverage trading
Selecting the right broker is critical when deciding to trade using leverage. A good broker will provide the necessary tools, resources, and support to help you understand the risks and opportunities associated with leverage trading. So, what factors should you consider when choosing a broker?
1. Regulation and reputation
You need to make sure the broker is regulated by the Australian Securities and Investments Commission (ASIC). If you choose a broker that is not regulated by ASIC, you are unlikely to have any recourse if something goes wrong. A regulated broker is required to adhere to strict guidelines and standards, which helps to protect your funds and provides a safer trading environment.
2. Leverage ratios offered
Different brokers offer different leverage ratios, depending on the financial instruments and the trader's experience. Therefore, I recommend you choose a broker that provides suitable leverage ratios based on your trading strategy and risk tolerance.
3. Trading platform
A user-friendly and reliable trading platform is essential, therefore, find a platform that offers charting tools and efficient order execution.
4. Commissions and fees
Compare the commission rates, spreads, and fees charged by different brokers. While low-cost trading is attractive, be careful of brokers who offer extremely low fees. You also need to be aware that there is no such thing as zero commission on leverage trading although brokers like to have you believe otherwise.
If a broker promotes zero commission, ask them how they get paid. Typically, brokers make their money in leverage markets from larger spreads when buying and selling the underlying assets, which means you will receive less profits or have increased losses.
5. Interest rates on margin
As I previously mentioned, you will be charged interest on the borrowed funds when trading with leverage. Compare the margin interest rates offered by different brokers and choose one with competitive rates.
6. Customer support
The broker's customer support must be responsive and knowledgeable. Look for a broker that offers multiple support channels, such as phone, email, and live chat, and has a reputation for providing good support.
7. Account types
Different brokers offer various account types for traders with different levels of experience and capital. Check that the broker provides an account type that matches your needs, such as minimum deposit requirements, leverage ratios, and access to specific trading instruments.
8. Execution speed and slippage
Fast and accurate order execution is critical in leveraged trading because even small delays can impact your profits or losses. Look for a broker with a reputation for providing efficient execution and minimal slippage.
9. Deposit and withdrawal options
Choose a broker that offers convenient and secure deposit and withdrawal options. Additionally, consider the processing times and fees associated with these transactions.
The reality of leveraged trading
Did you know that 90 per cent of individuals who trade leveraged 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 continually 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 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's 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.
Key strategy to reducing your risk
One of the strategies I teach my clients as part of my four golden rules to investing 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 to 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 bookstores.
I can categorically say, that if you follow my advice, you can become one of the 10 per cent that consistently makes money in the markets.
Is leverage trading right for you?
Deciding whether leverage trading is right for you depends on several factors, including your risk tolerance, trading experience, financial goals, and understanding of the markets. Before you venture into leverage trading, you need to consider the following:
1. Risk tolerance
As I continue to say, leveraged trading comes with significant risks because while it can increase your gains, it can also magnify your losses. If you have a low-risk tolerance or you're uncomfortable with the idea of substantial losses, leverage trading may not be suitable for you.
2. Trading experience
When using leverage, you need to apply tested trading strategies and risk management rules to protect your capital. If you're just starting, it's essential to gain the knowledge, skills and experience that will ensure your long-term success.
3. Financial goals
Consider your financial goals and objectives when deciding whether leverage trading is right for you. If you're looking for potentially higher returns and you are willing to accept the risks associated with leveraged trading, it might be suitable. But if your primary focus is capital preservation or long-term steady growth, it is unlikely that leveraged trading will align with your goals.
4. Time commitment
Leveraged trading often requires you to closely monitor your positions. If you're unable or unwilling to dedicate the necessary time and effort to manage your leveraged trades, it's probably not for you.
5. Emotional control
Leveraged trading can be emotionally draining, as you need to make quick decisions in a fast-paced trading environment. If you struggle to manage your emotions or make disciplined decisions under pressure, it's probably not something you should participate in.
6. Access to capital
While leverage trading allows you to control larger positions with a smaller amount of capital, you must have sufficient funds to cover potential losses and margin requirements. Given this, you need to ensure you have an adequate financial buffer before you engage in leveraged trading.
If you already have a well-diversified investment portfolio and you're looking to add a higher risk-reward component, leveraged trading might be a suitable option. However, if leverage trading forms a large portion of your overall portfolio, you need to consider the potential risks and your ability to withstand the losses. Remember, I recommend you don’t invest more than 10% of your total available capital in leveraged markets.
To determine if leverage trading is right for you, assess your risk tolerance, trading experience and financial goals. If you decide leveraged trading is for you, be sure to implement solid risk management strategies and continually educate yourself to improve your chances of success.
There you have it, my comprehensive guide to leverage trading. I hope this gives you the foresight needed to go into leveraged trading with open eyes.
Invest in yourself
Before I finish up, let me say that I cannot emphasise enough how important it is to equip yourself with the right knowledge and tools, so you can confidently trade in all market conditions. If you're serious about your success in trading leveraged markets, we have the resources to support you with our books and trading courses to ensure you have the right knowledge and skills. I can guarantee an education will pay you back tenfold if you decide to use leverage to trade. 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.
Others who read this also enjoyed reading: