Leverage trading is done to amplify the buying power of an investor in the market. Leverage trading is also known by the name of margin trading. It involves borrowing money or capital from a broker in the hope of getting a higher or larger potential return on the initial investment.
Lending allows the initial capital of an investor to increase, and their buying capacity also increases as a result. And this additional capital is used in buying more contracts – expecting the asset returns to be more than the amount borrowed.
However, it is sensible to remember that as much as leverage increases the chances of a potential reward in returns, it also raises the risk of exposure and therefore it is something practised only by experienced traders.
In business, the term leverage can also be used to refer to the debt amount used by a certain company to expand their assets. An instance of such leverage trading would be when a company uses debt money to acquire more assets to improve operations instead of issuance of new stocks to raise that capital.
What are the fundamentals of Leverage Trading?
Let us now learn how leverage trading works-
- It is through one’s broker that a trade on leverage can be carried through
- It is like receiving a loan amount which is used to buy an asset
- The investor, ie., you already have an initial capital. The broker adds on to it and pays a bulk of the capital in the purchase.
What should you know about leverage trading?
The difference amount is settled by following the difference of:
a) the money with which you bought the asset(also known as the opening price)
b) and the amount with which you sold your asset (also known as the closing price)
If you’ve made significant gains, then your broker’s share is paid from the profits of the trade.
In the event of a trade leading to a loss, the amount owed to the broker is calculated out of the money left in your account. For this reason, every trader does not readily have leverage trading facilities.
How much amount a broker will finance depends on several factors. Some of them may be :
-the regulations of current online trading in a certain jurisdiction or,
-what amount of leverage the trader demands
How does Leverage trading work?
To understand how leverage trading works, let’s look at what leverage ratio is.
Financial leverage is the ratio between equity and the total assets, where the total assets is the loan amount borrowed from the broker and your capital or equity. The equity amount is basically the amount you have deposited into your brokerage account.
Financial leverage = (Equity +Debt)/ Equity
Let’s understand this through an example.
Many traders are allowed a leverage of up to 100: 1 by their brokers, especially in the forex markets. This means that you can leverage the trading position by a hundred times.
For example, saying you have $3000. This is your equity or your capital.
If your broker also allows a leverage of 100:1, then you can leverage your buying position in the market as – $3000 x 100 , that is, $300,000
The profit or the loss amount will also get magnified by 100 times.
Many brokers also allow their clients with negative balance protection. This effectively stops one out before their trading account hits negative when there is a loss. When this protection is not provided, and there’s a loss, you’ll end up owing money to the broker.