The concept of “leverage” is often encountered by novice traders who do not yet have their own impressive capital, but want to have the opportunity to trade in the markets. What is leverage? What opportunities does it provide? Is this tool always useful? What are the risks when using leverage? What mistakes should you avoid when using leverage?
Leverage – what is it in simple words
Leverage is a brokerage service that is a loan in the form of cash or securities provided to a trader to secure a transaction. The loan size can exceed the amount of the trader’s deposit by 10, 20, 100 or more times. By analogy with the law of physics, leverage works as a lever, allowing a trader to enter into transactions that he would not be able to do with his own funds alone. The maximum leverage on the exchange does not depend on the desire of the trader and the capabilities of the broker. It is calculated based on the risks established by the clearing center for each asset. For example, if for any stock the risk amount is determined to be 10%, a trader will be able to trade it with a leverage of 1 to 10. If the risk amount is 30%, then it is impossible to obtain a leverage of more than 1 to 3.
Carrying out transactions on the stock exchange using leverage is called margin trading. It represents the conclusion of purchase and sale transactions using borrowed funds issued against the security of a certain amount, which is called margin. In other words, in order to use the leverage service, you must have a minimum amount on deposit (set by the broker), which will be the collateral.
The amount of leverage in trading is the ratio of the trader’s own funds to the transaction amount (1:100, 1:1000). For example, if this ratio is 1:500, then the broker is providing a loan amount that is 499 times the investor’s deposit. In this case, the transaction uses one part of the investor’s funds and 499 borrowed funds.
The word “credit” scares many people away, but in fact there is nothing scary about this concept. Leverage can indeed be called a loan in the usual sense of the word, but the interest on the use of borrowed assets is significantly less than the usual banking ones. When transferring transaction positions to the next day, a commission is withdrawn from the account in the amount of the difference in discount rates on the loan and deposit – the so-called swap, which can be considered an analogue of the fee for using leverage.
The loss on the transaction is deducted from the trader’s own funds; if, as a result, their volume becomes less than the permissible minimum margin value, the broker will send an alert that the money is running out and the trader needs to either replenish the account or close the position. This alert is called Margin Call. If no action is taken, the transaction will be closed automatically (Stop out).
Leverage calculation example
The trader’s account has 100 US dollars, the loan amount is 1:100, the transaction amount is 10,000 dollars. In this case, the broker credits $9,900 so that the transaction amount is 10 thousand.=
If the transaction is unprofitable, then when the trader’s funds decrease to $20, it is forcibly closed. The transaction account remains at $9,920. The borrowed $9,900 goes back to the broker’s account, the trader’s loss is $80.
If the transaction took place and the profit was $1,000, then the account will have $11,000 after the transaction is closed. Of this, $9,900 will go to the broker’s account, and the trader will receive back his $100 and $1,000 in profit.
Leverage: Pros and Cons
For many traders who do not have their own capital, leverage is a financial opportunity because it can help you gain access to serious trades and make good money.
At first glance, this financial instrument has only one advantage:
- allows you to conclude large transactions and make good profits;
- provides beginners with the opportunity to quickly increase their own deposit several times;
- allows you to place bets that exceed your financial capabilities.
But there are pitfalls when using borrowed funds. The main one is that leverage can increase the profitability of a transaction, but at the same time multiplies the risks. Therefore, the main task in margin trading is proper capital management. Let’s look at the advantages and disadvantages of leverage using a calculation example.
Let’s say a trader has $500 in his account and he decides to buy shares worth $100. Without using a loan, he will be able to purchase only 5 shares; he simply will not have enough money for more. But if he uses a broker’s loan of 1:100, he can afford to buy 100 times more shares, i.e. 500 shares.
If the deal goes in the desired direction, the value of the shares will increase. Let’s say it increased by $1 – then this will mean that when selling, the trader will receive an income of $1 from each share. It is easy to calculate that without the use of borrowed funds, the trader’s income would be only 5 dollars, and with them – 500 dollars. Not a bad result.
But the situation may be the opposite. If the transaction is unsuccessful and the price of the shares falls by $1, then without a loan the loss will be $5 – $1 for each share, and with the use of credit funds the loss will be equal to $500, i.e. the trader will lose his entire deposit.
Leverage for a trader and an investor: what is the difference
Trader and investor are different concepts. They trade the same markets, but use different strategies, which means they need different financial instruments. The leverage service will have features in both cases.