Trading with leverage allows you to open a big trade with just a little bit of money down. The deposit or amount you put down, is also called margin and is used as guarantee for the trade. The rest of the money is funded in advance by your broker.
Imagine your broker offering you a 1:100 leverage, this means that with just $100 down, you’ll be able to open a whopping $10,000 trade. Because of the higher value of the position, a very small change in price of the underlying asset can net a decent profit. In the examples below I will explain the differences between trading with and without leverage.
Example 1: Trading WITHOUT leverage
In this example we trade without leverage. We buy 1000 shares with a price of $20 each. Our total investment is 1000 x $20 = $20.000.
If the price per share increases to $30, our profit on this trade is $10 per share. Our net profit is 10 x 1000 = $10.000.
If we convert this to profit percentage we get 10.000 / 20.000 x 100% = 50%.
If the price per share drops to $10, we lose $10 per share. Our total loss is $10.000. So also 50% loss.
Example 1: Trading WITH leverage
Now we do the same trade again, but this time with a 1:10 leverage. We buy again 1000 shares, priced $20 each. Because of the leverage, our initial investment is a lot lower, being $20.000 / 10 = $2000. That’s 80% less compared to trading without leverage.
If the price per share now increases to $30, then our profit per share is still $10. So $10.000 total.
But the profit versus our investment is a whole lot higher compared to the same trade without leverage, being 10.000 / 2000 x 100% = 500%.
This is quite an extreme example of how leverage works, but I hope you realize the powers of it’s effect.
This short tutorial video explains you even further what leverage is and how it works:
Advantages of trading or investing with leverage
Simply put, you can still profit quite nice with just a small amount of investment money down instead of wagering the entire amount without leverage.
Imagine you only have let’s say $250 to trade with, then in most cases this is way to low to make a decent profit. If you want to buy a $25 share, you can only buy 10. If the price of these shares increases by $0,50 you only earned 10 x $0,50 = $5.
But if the broker offered you a 1:100 leverage, all of the sudden you would be able to buy 1000 shares and with the same $0,50 price increase, you would gain 1000 x $0,50 = $500.
Another nice feature of trading with leverage is that even with a small amount of investment money, you can open multiple trades on several different assets or financial instruments.
Risks and cons of trading with leverage
This trading with leverage all sounds nice and promising, but of course there are also some cons and risks involved.
The biggest risk is most likely the fact that you’re going to open bigger trades than you should. It’s very tempting to want to make more profit, but it’s not always the smartest move.
The loss on a trade with leverage can exceed your initial deposit. I’ll explain why:
Let’s go back to the example above. This time we assume the entire market crashes and our chosen stock or share goes to zero.
If we traded without leverage, we would have lost our initial deposit of $20.000. With our leveraged trade, two options or outcomes could be the case:
1. We had less than $20.000 on our account and we received a margin call the moment our account didn’t have enough margin in it to cover the trade.
2. If we had $20.000 or more on our account, we had already need to pay this when we opened the position.
Limiting leverage risks
Luckily, one can mitigate the risks of leveraged trading as professional trader. Here are some examples of risk management:
– Most brokers offer negative balance protection
– Always use a stop loss to automatically close losing trades
– Never risk more than 5 to 10% of your total account balance per trade
Suggested read: Plus500 review
Trading and investing with leverage is a wonderful thing, but always be cautious. Luckily most brokers offer a demo account with which you can practice online trading before you trade with your own hard earned money.Open Plus500 demo account
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