Trading using leverage
The trading industry is quickly evolving. Today, anyone with an internet connection and a computer or mobile device can trade the same instruments as Wall Street traders do. This contrasts with what used to happen a few years ago when trading was the reserve of large investment banks and hedge funds.
The evolution of the trading industry has led to the introduction of many products like options, social trading, and algorithmic trading. Brokers have also introduced new assets including cryptocurrencies.
To make it easy and more profitable for traders, these companies have also introduced margin and leveraged trading. These are two often-confused concepts of the financial market. Margin refers to a ‘loan’ extended to a trader by the broker to help them open larger trades. Leverage, on the other hand, is the increased buying power a trader receives when they use margin.
What is leverage trading?
The concept of leverage has been used by governments, companies, and individual borrowers for decades. In financing, it helps the borrowers increase their borrowing capabilities.
In trading, leverage enables traders to trade in assets that would otherwise be unaffordable. For example, the stock price of Berkshire Hathaway is currently trading at $300,400. This means that ordinary traders cannot afford to buy the stock. With leverage, traders can easily afford the stock, even when their account has less than $10,000.
The main advantage of using leverage is that it enables traders to buy and sell assets they would otherwise not afford. It also helps them make more profits than they would if they traded without leverage.
For example. Assume that two traders—Adam and Bruce—have accounts of $10,000 each. After doing their analysis, they conclude that the USD/JPY, which is trading at 120, will move lower. Their broker requires a 1% margin deposit. So, they open a short order, hoping that the pair will move lower.
Adam decides to use a leverage of 1:50 and shorts the USD/JPY pair with their $10,000 account. Using this leverage, Adam has placed a short worth $500,000 (10,000 × 50). One pip of the USD/JPY pair is worth $8.30. Also, assume that one pip of USD/JPY for 5 standard lots is worth approximately $41.50. Therefore, if the pair moves lower to 119, the trader will gain 100 pips, which is equivalent to $4150. This is a 41.50% profit.
Bruce, on the other hand, decides to place a short order with a leverage of 1:5. This trade is equivalent to a $50,000 short on the USD/JPY. If the trade moves by 100 pips to 119, the trader’s profit will be $415, which is 4.15% of the total trading capital.
Therefore, the size of leverage a trader uses plays an important role in determining the amount of profits they get per trade. If the trade goes right, a highly leveraged trader will always make more money than one who uses less or no leverage.
However, there are risks too when the trade doesn’t go in the expected direction. In the above example, if the USD/JPY moves to 121, Adam will lose $4,150—or 41.5% of the trade—while the other trader will lose $415, a mere 4.15% of the total capital.
How to trade using leverage
The first thing you need to do when using leverage to trade is to determine the size of the leverage. This is because the size of the leverage you use can make or break your account balance. A newbie trader should go for a lower leverage than an experienced trader who is knowledgeable about the risks of the markets.
Brokers like OctaFX offer different levels of leverage per asset class. This is mostly determined by the level of risks in these assets. For example, since cryptocurrencies are volatile assets, brokers set their leverage level lower than the less volatile currencies. In addition, brokers adjust the size of leverage when they expect a major market-moving event to help protect traders’ funds.
After determining the leverage you’ll use for your trading, you need to do your analysis to find the ideal entry positions. In leverage trading, an entry position can either be a buy—if you expect the asset’s price to move up—or a sell—if you expect it to fall. You should only initiate a trade after doing thorough analysis.
Tips on trading with leverage
Remember, like all forms of trading, leverage trading involves risks. This means that while you can make a lot of money trading, you can also lose it all. To minimise the risks, you need to do a few things. First, only open a trade after conducting thorough analysis. This should entail technical, fundamental, and sentimental analysis.
Second, ensure that all your trades are protected by a stop loss. A stop loss is the margin level where a loss-making trade is automatically closed. This is the maximum amount the trader is willing to risk per trade. This stop loss helps a trader reduce the risk of losing more money than originally planned. In most cases, it is recommended not to risk more than 5% of the total account balance per trade. Another way of protecting the account is using a trailing the stop loss order. A trailing stop loss is when you move the stop loss in the direction of a winning trade, which locks the profits that you make.
Third, avoid letting emotions take control of your trading. A common mistake among amateur traders is when they close a loss-making trade and then open a trade in the opposite direction without doing any analysis. Another mistake is when they extend the stop loss line of a loss-making trade with the hopes that the trade will reverse. In these two cases, the result is often that the trader ends up losing money.
Fourth, avoid being greedy when leverage trading. Greed can cost you a lot of money. For example, when your profit target is reached, instead of taking the profit, you decide to leave the trade open to make more money. Often, the asset’s price will reverse and you may lose money. You can avoid this by setting a take profit, which is the opposite of a stop loss. A take profit will close your trade automatically when your profit target is reached. Another example of greed is when you open many trades in a day after making a profitable trade in the morning. You can avoid this mistake by setting yourself a daily limit and sticking to it.
Leverage trading is an ideal way for traders to make significant gains in the financial markets, when it is practiced well. If done wrong, it can be disastrous to traders. Being knowledgeable, practicing, and having discipline can help you succeed as a leverage trader.