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Trading in financial markets involves significant risk of loss which can exceed deposits and may not be suitable for all investors.
Before trading, please ensure that you fully understand the risks involved
Trading in financial markets involves significant risk of loss which can exceed deposits and may not be suitable for all investors. Before trading, please ensure that you fully understand the risks involved

Leverage Trading Explained

Chart patterns are used by traders and analysts to identify potential entry and exit points in the markets.

What is leverage in trading?

By using leverage, you can gain exposure to larger trading positions with a smaller amount of capital. Leverage of 10:1 means that margin is one tenth less than transaction size to open and maintain a position. So, if a trader had an account value of £10,000, using leverage, they could enter a trade for £100,000.

The margin amount refers to the percentage of the overall cost of the trade that is required to open the position. The margin requirement for a trade of £10,000 using a leverage ratio of 10:1 is $1,000.

When trading contracts for difference (CFDs) in financial markets, leverage is used. You can trade CFDs across a variety of financial assets, including forex, indices, commodities and shares. Of course, some markets are more volatile than others. Leverage may therefore be limited to smaller multiples of capital. In forex leveraged trading for example, retail leverage rates can start at around 30:1, compared to around 5:1 for shares. You can also find different leverage rates depending on whether you are a retail or professional trader. While retail leverage rates for forex are around 30:1, they are around 500:1 for professional clients. To qualify for higher leverage rates, professional clients must meet strict criteria.

Leverage can sound like a very appealing aspect of trading, as winnings can be immensely multiplied. But leverage is a double-edged sword – it is important to remember that losses can also be multiplied just as easily.

How to trade leverage

Understanding CFD margins, leverage, and the difference between them can be confusing. It is important to know that margin is the amount of capital required to open a trade. Leverage is the ratio applied to the margin to determine the size of the trade. Leveraged trading in financial markets is more likely done by those who trade short-term price movements and by day traders. It is not very suitable for those who make long-term investments such as several years or even decades. In this case the "buy and hold" approach is more appropriate. Given the short-term duration of most currency and CFD trading, it makes sense to use leverage to increase your trading ability.

It is important for all traders to keep in mind the risks involved in trading with leverage. Many financial market traders find that their margins are being wiped out incredibly quickly due to excessive leverage. Beginners should be extra careful when trading on margin. It is best to be more cautious and use less leverage. Low leverage means that traders are less likely to wipe out all their capital if they make a mistake.

Traders are advised to start with a leverage lower than the maximum allowed leverage. This allows traders to keep their positions fully open even in the face of negative returns. For example, suppose a trader has his maximum leverage of 10:1 and opens a position with that leverage on a $10,000 account.

The trader currently has a position size with an equity value of $100,000. This means that a 1% price move will completely wipe out your position. Also note that the broker can reduce a trader's position if the position has lost his $5,000. This is because the trader has only $5,000 of available capital and a leverage of 10:1 means the maximum position allowed is $50,000 instead of $100,000.

With reduced leverage, with an initial investment of $10,000 he goes 5:1, the position is $50,000 and a 1% move is $500. Keeping leverage ratios low means that traders are less likely to wipe out all or most of their capital if they lose money.

Calculating leverage ratios

An important aspect in using leverage is understanding how to calculate the ratio. The formula for leverage is:

L = A / E

where L is leverage, E is the margin amount (equity) and A is the asset amount.

So, dividing the asset amount by the margin amount gives the ratio of leverage.

It is also possible to start with the margin amount and apply a leverage ratio to determine the position size. In this instance the formula would be A = E.L. Therefore, multiplying the margin amount by the leverage ratio will give the asset size of a trader’s position.

Most traders distribute risks across different markets, meaning they are not putting all their eggs in one basket. This could be done by taking various positions in different markets. When this is the case, there may be the need to do calculations to determine things like net asset value, or the accumulative value of a trader’s positions. Thanks to platform technology that most brokers will offer, it is easier to monitor all parameters and open or close individual positions as needed. More importantly, it can help a trader work out if positions fit within their total leverage amounts, which should be less than the maximum leverage allowed by the broker.

Risk and leverage trading

The risk associated with leverage is the most crucial concept to comprehend in financial markets. Any sort of trading involves risk, but leverage can increase both profits and losses. Trading professionals would be wise to take special care when deciding how much leverage to utilize. Prior to trading, the leverage ratio should be established. If you have a run of profitable trades, it might be very tempting to trade in a larger size than what was originally planned.

If a trader decides to take a one-off risk and wins the transaction, they may benefit from doing so. But if it's done incorrectly, a trader risking a considerably greater loss than usual. To help reduce risks in trading, you should plan out your trading strategy in advance.

How much risk to take on each trade and how much risk to take on each day could be considered when deciding how much leverage to apply to a portfolio. It is simpler to examine this in terms of percentages. A trader can first choose how much risk they are ready to face daily. This entails determining the most money a trader is willing to lose in a single trading day. For instance, it might fall between 1% and 2%. If a trader uses 2% as their daily maximum risk, it will take 50 days of consistently losing transactions for them to lose all their cash, which is a scenario that should be exceedingly uncommon.

The number of deals a trader wants to execute each day should also be decided. This value may be a minimum or a maximum. For instance, a trader might decide to make three trades every day regardless of the market. Or they will only execute three trades each day at most. The trader can in each scenario split this number by the percentage they are willing to risk each day.

Source: CMC Markets UK


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