The global financial market is a complex and increasingly diverse entity, and one that’s often cloaked in confusing jargon (depending on your chosen market niche and asset class).
Some terms are also used across a number of financial markets, with ‘leverage’ offering a relevant case in point.
In this post, we’ll explore the concept of leverage in further detail, while asking how this works and whether or not it’s right for you to consider as a trader.
What Is Leverage?
In simple terms, leverage refers to the use of debt or borrowed capital to open and control large investment positions. This is with a view to amplifying returns and accessing asset classes even with a nominal deposit amount.
On a fundamental level, leverage can be deployed to boost a trader’s buying power in a particular market, while this is usually expressed as a ratio and may reach 200% when dealing with some licensed forex brokers.
Leverage is commonly associated with practices such as CFD trading, which are speculative in nature and enable you to operate without assuming ownership of the underlying asset.
Leverage is also closely linked to margin, and you may hear both of these terms regularly when opening a brokerage account. In this relationship, margin refers to the amount of capital used to create leverage, with this expressed as a percentage deposit required.
How Does This Work?
As we’ve already said, leverage trading can be deployed across a number of markets and asset classes, including forex and stocks.
The most common iteration of this practice involves trading on margin, which requires you to borrow money from your broker to open an optimal position. Leverage will be available at a variable percentage depending on your broker, with this expressed as a ratio to the margin provided.
At this stage, the capital and alternative securities in your brokerage account are used as collateral, minimising the risk from a brokerage perspective and safeguarding the money borrowed.
Of course, it’s this that makes trading with leverage such a risky pastime, as you can also lose significantly more than the value of your deposit if the market turns against you.
The Key Considerations When Trading Leverage
Given the delicate risk-reward balance when trading leverage, there are a few key considerations that should help to inform your decision and strategy. These include:
- Buying Power: The term ‘buying power’ refers to the precise amount of capital that you have available to buy and trade securities. This includes leverage, creating a comprehensive overview and value that can be greater than your cash account balance.
- Coverage or Risk Ratio: This is a fundamental indicator that you should always monitor as an investor, as it represents the ratio of your net account balance in relation to the leverage amount. In short, this is the amount that will be lost if the market turns against you.
- Margin Calls: If the coverage or risk ratio relevant to your account falls below the minimum requirement to maintain your leveraged position (as laid out by the broker), a margin call will be administered. This serves as a warning to the investor that the current risk exposure is higher than the level allowed by the bank.
By understanding these terms and experimenting with variable leverage through a demo account, you can begin to use this to your advantage across a broad range of markets.
However, it’s crucial that you tread carefully when first trading with leverage, as the risk of losing considerably more than your deposit can be highly damaging and should be avoided at all costs.