What is Leverage Trading? [The Good, Bad, and Ugly]

Leveraged trading, also known as trading on margin is offered by most major brokers. This type of trading allows a trader to multiply the value of their trades. This means that a trader can open a position with a value more than the funds used to open that position.

Day traders who choose to trade leveraged products do so to seek accelerated returns. The more leverage, the more potential for higher returns, this is popular with traders with a smaller account. The opposite is also true, trading with leverage can lead to large losses. It’s important to have a trading strategy, and excellent day trading risk management techniques when trading leveraged products in volatile markets.

To use trading leverage you use borrowed money from your broker allowing you to increase your position size. As the trader you are only required to have the margin available. The margin is a fractional amount of the position size.

Once the trader closes out their position, they must return the borrowed funds to the broker. The trader will then either receive or pay the difference. If the trade is profitable, the trader gets the difference in price, otherwise the trader pays the difference.

This gives traders the ability to open positions of a size not possible using a smaller account. Trading leverage is described as a ratio which indicates the funds utililised against funds borrowed. For example, a ratio of 1:10 would mean that you can leverage each dollar up to 10 times.

Let’s say that, for this example, your trading leverage is 1:10 and are placing $100 on a trade. You have 10 x the buying power, the value of your trade is now $1,000 (10 x $100).

This trade multiplies potential profits based on the amount of leverage. This trade also multiplies potential losses. In this example, profits are multiplied by 10, as are losses.

For this example, let’s say that the movement in price was $5. If the trader predicted the correct direction for the trade, the profit is 10 x $5 = $50. If the trader picks the wrong direction, then the loss is $50.

On this trade the initial margin (funds needed to place the trade) is $100. Depending on volatility and movement against the trader, this can change. If a trade moves against the trader enough the margin required grows. If the margin required nears the total funds in the account, the trader may receive a margin call.

1. Increased Risk:

Trading leveraged products carries a larger risk than not trading with leverage. The increased size of potential losses means it’s important to track and manage trades.

2. Losses can exceed funds available:

Depending on the broker, you may be liable to pay back your broker should you lose more than your full account. If you are using a 2:1 leverage, your losses would be doubled. That means that if an asset loses more than 50% of its value, you’ll lose more than 100% of the cash you had available to invest.

Because of the increased risk involved in trading leverage, you need to be a good risk manager. You should always use a stop loss and risk management techniques to avoid massive losses.

A large loss may lead you to receive a ‘margin call’ from your broker. A margin call will be a demand to deposit further funds. This can happen because your broker worries about your ability to repay your debt if your investments continue to lose value.

Some brokerages will provide negative balance protection. This means that you will be exited from a trade rather than go into the minus.

If the broker doesn’t offer this, risk is technically unlimited. If ill managed, you could end up owing your broker money.

To reduce the risk of trading leveraged products, first limit the size of the leverage you use. While trading leverage adds more bang for your buck, so to speak, the greater the leverage the greater the risk.

Use a Stop loss:
You should also trade using a stop loss for every trade you place. This will ensure that you control the maximum amount of money at risk each time you trade. Because there is limitless risk with leverage trading, it’s important to manually add that limit.

Have a maximum risk allowance:
Have an initial risk in mind before placing the trade, this forms the stop loss. I choose to use the rule of no more than 2% of my account size per trade. If my technical analysis on a trade says my stop needs to be more than 2%, I don’t take the trade as it is too risky for me.

Make your reward to risk in your favour:
You should always have a risk reward ratio of 1:1 or better. 1:1 means that your reward is equal to your risk. I usually look to have my reward to risk at 2:1 as it is a good balance between achievable and maintainable.

If I have my reward to risk at 1:1, I need to have a win rate above 50%. If all my trades are 2:1 then I can be profitable around the 40% mark. It might sound like making the reward much, much bigger than the risk means you rarely need to be right. While you can be correct less often, it is much harder to be correct.

Make your position sizes appropriate:
You should only open a position if it is allowed within your risk limitations. Leveraged trading can be risky and a larger position can compound out of control. Trading is about accumulation, not about getting rich quick.

Leverage trading is a risky proposition that can lead to large losses if not done correctly. Be mindful of risk management

When it comes to leveraged trading, there are definitely good and bad aspects to consider. Make sure you weigh the pros and cons before deciding if leveraged trading is right for you.

If you’re interested in learning more about leverage trading, check out our next free trading class.