Leverage Trading: Is It Good?

Leverage involves the use of a smaller amount of capital that can expose you to larger trading positions. Traders can make use of leverage across a wide range of financial markets, including indices, commodities, forex, stocks, and exchange-traded funds.

When you borrow funds from brokers, you can magnify your potential returns on investment. This is an advanced trading strategy that requires a full understanding before consideration. For this reason, this guide will look into the possible upsides and drawbacks of leverage trading. To know more, keep on reading.

How Does Leverage Trading Work?

Before you start trading on leverage, you should begin with leverage that is less than the maximum leverage allowance. Let’s explain better with an example.

If you wish to invest in a company that trades at $15 per share with $45,000 in your brokerage account. Without leverage, you can purchase 3,000 shares. However, you can trade on margin by borrowing $45,000. By doing so, you can double your purchasing capability by buying 6,000 shares.

If the price of the share rises to $20 per share, you can sell the shares for $60,000 while making a gain of $15,000 without leverage. However, by trading on margin, your shares can be sold for $120,000. After returning the money borrowed, this becomes $75,000 and a net profit of $30,000.

However, if the share price falls to $10, the shares can be sold for $30,000, resulting in a loss of $15,000 without leverage. With leverage, you can sell the higher number of shares – at the same price – for $60,000. After paying the money borrowed, you are left with $15,000, resulting in a loss of $30,000.

If the share drops to $5 per share, the shares are sold at $15,000, resulting in a loss of $30,000. If leverage trading is involved, you can sell the shares at $30,000. What this implies is that you will still owe your broker $15,000 despite selling all your shares.

Traders, who are looking to trade on short-term price fluctuations, are more likely to consider leverage trading.

Pros and Cons

Trading on leverage comes with some upsides and downsides that must not be ignored. This section will discuss them better.

Advantages

The joys of leverage trading are introduced as follows:

Your profits are magnified

With leverage trading, you can improve your purchasing power. With a positive price movement, your profits can be magnified correspondingly. In other words, if you multiply the sum of money invested by your leverage, you can make more money when your selling price surpasses your buying price.

Access to Higher-Value Stocks

If you are new to trading, trying to monitor many short-term trades simultaneously is not ideal. You could make use of leverage to achieve a larger position. However, this comes with risk, but the odds are better when you consider the overall market strategy.

You can start with little capital

This is one of the best benefits of leverage trading. Typically, trading on leverage can help you free up some capital since you only need to invest a fraction of the overall value of the assets you are investing in.

Disadvantages

Some of the drawbacks of leverage trading are explained below:

Magnified Losses

Leverage trading is often viewed as a double-edged sword. Your losses can be magnified as much as your profits. This makes it essential to have a trading strategy. To prevent getting stuck in dangerous positions while using leverage, adhere to your stops.

Higher Fees

Leverage does not only have the potential to magnify your losses, but also increase the transaction cost. Simply put, the higher the leverage, the higher the transaction cost as a fraction of your trading capital. This can reduce the amount of profit you make eventually.

Conclusion

The aim of engaging in trades is to make profits. Leverage trading is an advanced strategy that is adopted by experienced traders to increase their purchasing power, even with a little amount of capital. Yet, the risks that are associated with leverage trading cannot be stressed enough. For this reason, trading is carried out carefully as proper risk management is implemented.