In financial markets, Leverage refers to trading in excess of principal by borrowing funds from brokers/dealers to open positions. As a result, investors will have more flexibility to trade with less capital for higher returns. In this article, ZFX will introduce you to examples and methods of leveraged trading.
What is Leverage?
Leverage is typically expressed as a multiple or ratio. Assuming that the leverage ratio is 1:100, that is, the total investment is 100 times the trader’s principal (in CFD trading, the leverage ratio can be as high as 1:2000). Although an investor’s principal, or margin, is only a fraction of the total value of a trade, the trading profit or losses (P/L) are still calculated in terms of the total trade value, so the P/L ratio is magnified.
Here’s an example of how leverage can affect potential profits or losses:
- If you buy $1,000 of assets with $1,000 and no leverage is applied, you earn $10 for every 1% increase in the price of the assets you invest in. Otherwise, you will lose $10, which is 1% of the principal of $1,000.
- But if you also invest $1,000 and apply 10 times leverage, you can buy assets worth $10,000. So if the asset price goes up 1%, you’ll make a profit of $100, or you’ll lose $100.
Borrowed capital is used to magnify your trading results. As you can see from the example, 10x leverage can magnify the potential gain or loss from 1% to 10%.
Relationship between margin and leveraging
Margin refers to the funds paid in advance in order to ensure the performance of some obligations, and its essence is the credit deposit.
In leveraged trading, margin is capital invested by an investor and is essentially money paid to a bank, broker, or counterparty to open and maintain positions. Margin level is the ratio of margin to the total amount of contracts to be bought and sold, also known as leverage ratio or ratio.
Margin level =1/ leverage ratio
If the margin level is 0.2%, then the leverage ratio is (1/0.2%) = 500 times
Investor’s capital (margin) = total trading value/leverage ratio
If an investor wants to trade a $10,000 contract with a leverage of 500 times, he needs to put in at least $20 as margin to open a position ($20 = $10,000/500 times).
$20 is the initial margin required to open the position. There is also a minimum margin requirement (also known as margin call) in the general trading rules, such as 20% and 30%, which is established to ensure that the margin investors put in is maintained at a level that can offset the potential losses from holding contracts.
Take an example of forex trading. An investor buys a standard 100,000 euro contract when the exchange rate of EUR / USD is at 1.14. If the leverage ratio is 1:400, the required margin for the investment is ($1.14 x 1 x 100,000/400)= approximately $285.
Margin = contract price x number of lots x units per lot/leverage multiples
If the minimum margin requirement for this contract is 30%, the broker has the right to force the closeout of the Euro contract if the floating loss on the contract results in a net account value of less than $85.5 ($285 x 30%). The idea is that the investor may not have sufficient margin to maintain and perform the contract. It should be noted that different brokers have different requirements and criteria for the calculation of margin requirement and the execution of forced closeout.
As can be seen from the formula, the margin requirement is inversely related to leverage ratio. The larger the leverage ratio is, the less margin is required, and vice versa. However, a higher leverage ratio does not mean that the investor will put in less initial margin. In fact, investors may need to put in more margin as necessary to ensure that the contract won’t be closed out easily.
Pros & cons of trade leveraging
The most obvious advantage of leveraged trading is that it can bring greater profits to investors. By incurring relatively small costs, investors would be able to capture the investment opportunities in the market easily and conveniently.
However, when a position goes against an investor, losses can be multiplied by leverage, just as gains are magnified. If leverage is used inappropriately and risk management is not in place, it will bring additional risks to investors
The concept of leveraged trading or margin trading is the same in the sense that both of them have quite a low threshold for entry and possess the characteristics of two-way trading, amplification, and return of spread, which make them extremely attractive options for investors.
Investors who choose to use leverage should be aware of the risks involved, carefully control the degree of use, and develop appropriate strategies to avoid unnecessary losses.
Investors should consider taking the following measures as risk management when trading with leverage
Stop-loss can limit your loss by closing your position at a pre-set price when the market is unfavorable to you. You can set it according to the market price or set a specific range or amount.
Take-profit allows you to automatically close positions and make profits when the set target price arrives. This prevents you from missing the ideal opportunity to sell when you are too busy to trade
Negative balance protection
In rare cases when the net value of your account becomes negative due to market conditions, some brokers may fill in your losses and reset your net account value to zero.
Leverage trading is a double-edged sword, which can magnify both profits and losses. A correct mindset is very important, and risk management tools must be used.
Related Article: Risk Management Tips for Forex & CFD Trading
Risk Warning: The above content is for reference only and does not represent ZFX’s position. ZFX does not assume any form of loss caused by any trading operations conducted in accordance with this article. Please be firm in your thinking and do the corresponding risk control.
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