Trading – in any form and in any financial market – is a highly complex process, consisting of several different components. In order to have the most success as a trader, it is highly advised that you master each of these components and understand them fully.
With this in mind, one key aspect of trading which can significantly impact your chances of potential profit, is the inclusion of leverage. Trading with leverage can, when executed correctly and strategically, be a huge aid in your trading success, but first, you must comprehend how it is executed.
In this article, we will answer the key questions for you – What is leverage in trading? And how does trading with leverage work?
What is leverage in trading?
In every financial market, in order to trade, you need to first invest an amount of money. The money you put in (a margin) secures your trading position in the market with a particular asset, whether it’s through full ownership in traditional trading, or with a financial derivative, such as a contract for difference (CFD). This is a fundamental of trading.
The amount of money you deposit and the level of exposure you gain, however, is affected greatly when leverage is introduced. Leverage is a process within trading, determining the exposure gained in relation to your margin, calculated through a leverage ratio on the asset.
Your exposure will be much greater than the margin deposited, due to leverage. Whereas owning an underlying asset would require full cost of your position, traders need only to put down a percentage of the amount when trading with leverage.
This process is essential for a vast number of traders across the financial industry, so it would be beneficial to know how it works.
How does trading with leverage work?
Trading with leverage works slightly differently to other forms of trading, and requires a thorough knowledge of the process in order to execute it affectively.
You first need to establish the trade you would like to make. Different platforms will allow leverage on different types of trades. However, let’s say for this example, we’ll use a CFD trade on the foreign exchange (forex) market, trading a particular currency pair.
Once you’ve determined your trade, you will need to know the leverage that can be applied on this particular forex CFD trade. The leverage ratio will differ across different trading platforms, asset types, and markets. For this example, we’ll assume the maximum leverage on this particular trade is 1:30.
With this leverage, it would mean that if you wanted to gain £30,000 worth of exposure in the forex market, you would only need to deposit a margin of £1,000 when opening the trade. Likewise, for a margin of £3,000, you would gain £90,000 worth of exposure, and so on.
Once you have opened up your position, the price movements will alter the level of profit or loss on your trade, based on the £30,000 exposure, not the initial £1,000 margin.
For instance, with this higher level of exposure on your trade, it means that you can potentially make a huge profit from the price movements, all from a significantly less deposit amount, should the trade go in your favour. This is why many traders opt for leveraged exposure in trading.
However, it is absolutely essential that you are aware of how leveraged exposure applies to your entire trade. By this, it means that exposure will magnify your losses as well as your profits. This would mean that, say you made a loss on this example trade, your loss would be based on the full £30,000, even though you only put down a margin of £1,000.
It is pivotal that you apply caution and thorough planning to your trades with leverage, to increase your chances of profit successfully, and not incur unpredictably substantial losses.
That being said, now that you know how trading with leverage works – and the necessary weariness needed – you are more than equipped to begin incorporating leverage into your own trades, for the best chance of profit and success.
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