What Is Leverage in Trading? How to Use It to Your Advantage
If you’re new to trading, you may have heard the term “leverage” thrown around and wondered what it means. It’s by far one of the most important stock market terms. Many traders swear by it, while others believe that it’s nothing more than a recipe for disaster.
So what is leverage in trading? How can you use it to your advantage? And what are the risks involved? Our latest article will explore all of these questions and more.
Let’s get started!
What Is Leverage Trading?
Simply put, it is the use of borrowed money to increase your potential return on investment. With leverage trading, you’re essentially borrowing funds or otherwise increasing the number of shares involved in order to trade more than you could with your capital.
For example, let’s say that you have $1000 in your trading account. If you leverage an additional $4000, you could trade $5000 worth of currency. This way, you’ll increase your potential profits by an impressive five times.
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How Can You Use Leverage in Trading?
Now that we’ve been able to define leverage as a concept, let’s take a look at how you can use it when trading. There are several ways that you can take advantage of leveraging, including:
Trading on Margin
With margin trading, you’re essentially borrowing money from your broker to buy securities while using the remaining securities in your account as collateral. The amount of money that you’re able to borrow differs depending on the broker but is typically around 50% of the value of your account.
Having said that, let’s assume that you have $1000 in your leverage account and you’re using a 50% margin. This means that you can borrow up to $500 from your broker to buy securities.
In cases like this, your broker may require that you maintain a minimum balance of $750 in your account to cover potential losses. Your margin level will tell you how close you are to this minimum balance.
Trading on Options
In trading, options are derivative contracts that give you the right, but not the obligation, to buy or sell an asset at a specific price within a certain timeframe. Obtaining an options contract gives you complete control over 100 shares for much less than the cost of actually buying 100 shares in that same company.
With leverage trading, your broker will allow you to buy or sell options with a higher value than the amount of money in your account. However, it’s important to remember that options are quite a risky investment because their inherent value is based on the underlying asset, which can be more volatile than trading stocks or other securities.
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Leveraged exchange-traded funds (ETFs) are pretty popular because they offer the potential for high returns. These ETFs aim to provide two or three times the return of the underlying benchmark index. So if the benchmark index goes up by five percent, the leveraged ETF may aim to provide a ten or fifteen percent return.
Essentially, when you’re investing in a leveraged ETF, you’re betting that the underlying index will go up. But it’s essential to keep in mind that these ETFs are designed for short-term trading rather than long-term investments.
Leverage Trading Risks
All of these investment strategies are quite appealing since they can help you make more money than you could have otherwise. However, it is crucial to remember that leveraged investing in Canada also amplifies your losses.
So, if the trade goes against you, you could end up losing a lot of money very quickly. Let’s take a look at some of the most common risks associated with leveraging.
The risk ratio is the amount of money you’re willing to lose for every dollar you hope to gain. Since leverages double your gains, they may also double your losses. If your ratio becomes too high, you may find yourself in a situation where you’re losing more money than you’re making, despite using stock leverage.
A margin call is when your broker asks you to deposit more money into your account because the value of your securities has fallen below a certain threshold. If you’re unable to do this, your broker may sell some of your securities to cover the losses.
Unlimited Loss with Options
Another risk to consider when leveraging is that options may lead to unlimited losses. The more the market value of your assets rises, the greater your losses become. Since there’s virtually no limit to how high the market value can go.
Leveraged EFTs Aren’t Long-Term
Finally, it’s important to remember that leveraged ETFs are not meant for long-term investments. These funds are designed to provide short-term gains by matching the one-day index performance. In the long run, the overall returns on equity might differ significantly from benchmark values.
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All things considered, leverage is a powerful tool that can be used to magnify both gains and losses when trading. It’s important to remember that it comes with a certain amount of risk, and you should only use it if you’re comfortable with the potential for losses. And that wraps up our answer to the question “What is leverage in trading?”.
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When you buy stocks, you’re essentially buying the company’s shares. This makes you a shareholder, and you’re entitled to a portion of the company’s profits.
No, you don’t. But if you’re using leverage, you may have to put up more money if the value of your securities falls below a certain level.