Leverage
Leverage is the ratio of borrowed capital to equity (own funds).
This term is not accidental, since it is a margin provided by a broker to a private investor. This is not exactly a loan in the classical sense of the term, since the investor will not always pay interest on the use of funds.
But first things first. Let’s look at the work of leverage using an example.
Trader N. has been trying to engage in trading for a long time. He understands how trading is organized, the basic principles and methods of work, and he decides to make a big deal. Obviously, his profit will depend on how much money he can invest. He has $1,000 in his account, and if the outcome is positive, he will have $3,000. But if the initial amount is higher, then the profit will be higher. N. is confident in his strategy, so he takes $9,000 from the broker. The deal turned out to be successful, and N. got his profit.
The leverage can be any. In financial markets, leverage is expressed as the ratio of the trader’s equity to the total position size. In the example of our hero, the ratio was 1 to 10.
Leverage is mainly used if traders want to increase profits. But sometimes a trader cannot get the minimum amount to complete a transaction, and he is forced to use leverage.
If the transaction is successful, the private investor will receive the profit after financing costs.. The broker does not have the right to claim this amount, but may request a small interest or financing fee for the service.
Risks of Trading with Leverage
When transferring their funds, the broker strives to protect them as much as possible. The broker sets a margin close-out level, typically at a percentage of the trader’s equity. In simpler words, this means that the trader’s money becomes collateral for the duration of the transaction.
If the transaction does not go according to plan, the broker will send a notification to the private investor about the adverse position (margin call). In response to this action, he can replenish the balance to the required amounts or close the trade. If there is no action on his part, the deal will close (stop out).
In this case, the trader’s funds are likely to burn out. The broker will return all his investments, and if the trader has used them for more than a day, he will also incur transaction costs.
With proper work with leverage, risks can be reduced in two ways:
- Set a stop-loss level — the price at which a trade is automatically closed to limit losses.
- Do not try to break the whole “jackpot”.
Leverage Trading Strategies
As a rule, leverage is used when working with two strategies.
- Long position (going long). A trader buys shares for less and sells them for more. In order to make a big profit, he requests leverage from the broker. In case of a successful transaction, the investor earns on the difference received. You can hold such assets for as long as you want — days, months, years.
- Short position (going short). The trader makes a profit in the event of a stock drop. How it works: a trader takes securities from a broker and sells them at a high price. When the price of them drops, he buys them back and returns them. The difference that the trader earned on these operations remains to him.
As with long positions, short ones can also be held as long as you want.
Long position players are called bulls; those taking short positions are bears, as they say in stock exchange slang.
So, leverage is an excellent financial tool for those traders who know how to use it competently. Otherwise, the trader will only incur losses.