Leverage is a financial concept that allows traders to increase their investment capacity through borrowing. This mechanism, often seen as a double-edged sword, allows the increase in equity using borrowed funds under certain conditions.
In practice, it allows traders to open positions significantly larger than the amount of capital they own, providing a multiplier effect and allowing them to gain exposure to large volumes of securities, currencies, cryptocurrencies, or other financial assets.
Trading leverage is the ratio used to determine how much a broker will give a trader relative to their initial deposit.
For example, a leverage of 5 allows a trader to open a position of $1,000 with $200 of equity :
Leverage is offered by brokers who offer, for example, CFDs. It works through a virtual loan, where the trader does not directly borrow funds but opens a position whose value is greater than his capital.
The initial deposit, known as the “margin”, represents a fraction of the total value of the open position.
Be careful with leverage.
Please note that using leverage carries high risks and is mainly suitable for experienced traders. While offering the opportunity to make exponential profits, leverage can also lead to significant losses, which can lead to a complete liquidation of the capital put at stake.
Example of leverage with a cryptocurrency
A trader opens a $100 position on Bitcoin (BTC) with a leverage of 1:2. This means that the total amount actually invested in the market is $200.
If Bitcoin’s value increases by 10%, the trader’s position is worth $220 ($200 * 10%), and the profit is, therefore, $20.
However, using leverage involves high risk, as potential losses are also magnified. If Bitcoin loses 10% of its value, the trader’s position decreases to $180 ($200 – $20). The realized loss is, therefore, $20, which is equivalent to 20% of the trader’s initial amount. If the loss continues to 50% of the initial value of Bitcoin, this is equivalent to the trader’s entire initial amount. The trader’s position is then “liquidated.”
Example of leverage in Forex
A trader uses a leverage of 1:5 to invest in the EUR/USD currency pair on the Forex market. For every euro invested, the broker then lends an additional $5 .
Therefore, if the EUR/USD currency pair increases by 1%, the trader multiplies his profit by 5. However, if the pair decreases, the losses are also multiplied by 5, which illustrates the risky nature of leverage.
Example of leverage in the stock market
Suppose a trader wants to invest in company shares, which are trading at $10 per share.
Without leverage, with a capital of $1,000, the trader could buy 100 shares.
Using 2:1 leverage, the trader could control 200 stocks with the same starting capital.
If the stock price increases by $1, the initial investment would produce a profit of $100 (10% return), while the leveraged investment would produce a profit of $200 (20% return).
The Many Dangers of Leverage You Should Know About
Although the use of leverage offers significant benefits, such as profit amplification and increased investment capacity, it is also associated with considerable risks.
Indeed, traders expose themselves to risks of amplified losses by using leverage. Just as it can increase profits, leverage can also cause losses, potentially beyond the initial capital invested.
When the loss is equal to the initial capital invested, the position is “liquidated.” This means that the trading platform automatically sells the open position, and the invested capital is definitively lost.
Additionally, leverage exposes investors to margin calls: If a position moves against the trader, the broker may demand a “margin call,” requiring the trader to provide additional funds to keep the position open. Excessive leverage can lead to insolvency.
To mitigate the risks associated with leverage, investors and traders can adopt various strategies, such as diversifying investments, using financial products with limited risk, and rigorously analyzing the profitability of the investments considered. Also, the use of stop losses, profit limits, and a rigorous trading strategy are essential to protecting one’s investment capital.
It is essential to remember that trading is a profession that requires knowledge and experience. The use of leverage cannot be improvised and is generally reserved for those who fully master the market’s mechanisms.
If you do not have a trader’s experience, it is advisable to opt for a long-term investment approach, which is more stable and potentially less risky. This allows you to gradually build your investment portfolio while limiting the risks of significant losses.
