Leverage Trading: What You Need to Know Before Buying on Margin

Leverage trading, also known as trading on margin, is a widely-used practice that allows you to trade without paying the full amount of the position.

While I have used leverage trading in the past, it has worked both for and against me at times. Typically the former,  as it is a really risky thing to do but you need to understand leverage trading to help you fully immerse yourself in the stock market.

Leveraged trading is available for all asset classes and it is can be one of the most efficient ways to use your capital while aiming for more profit potential. It can also prove to be very dangerous — especially for those new to the stock market.

Let’s discuss more about leverage trading and buying on margin and see how it works, and why it may not be the best idea.

What is Leverage Trading?

leverage trading
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In the stock market, leverage trading is using borrowed money you get from your broker to increase your position size on the desired asset.


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For example:

Let’s say you’re a big Apple fan, the stock is booming and you have enough knowledge to invest in it. You’re 100% ready to proceed but you don’t have enough capital in the account to buy $10,000 worth of stock. Leverage trading makes it possible to invest only around $3,000, buying the rest of $7,000 in margin.

Since leverage trading works like a loan, this means you have to pay it back at some point, with interest. This makes it carry a high degree of risk, given the fact that there’s always the possibility for the trade to go against you. If the stock price moves against you, you’ll still have to pay the amount back that you borrowed.

While leverage is applicable to all asset classes, such as stocks or commodities; it is primarily used to trade on the Forex markets, which we will discuss next.

How Does Leverage Work in Forex?

Leverage can be one of the best tools to maximize your trading potential in the Forex markets.

Many Forex accounts allow you to buy on margin at ratios up to 50:01, which means you only have to put up $10,000 to control a position worth $500,000.

How crazy is that?

For instance, if you wanted to do this you would need to open an account with a licensed online broker that offers these ratios and opt for the leverage ratio you want. In order to use it efficiently, it’s important to choose the suitable leverage ratio according to the asset you want.

The amount of leverage provided can have some of the following ratios: 50:1, 100:1, or 200:1.

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These ratios typically depend on the broker you’re trading with, the jurisdiction of your location, as well as on the total volume of the open positions.

Before you start trading on leverage in Forex, you should learn the basics.

Balance

Your balance shows the size of your trading account.

Equity

Equity shows the value of the account.

Margin

Margin shows the blocked collateral.

Free Margin

Free margin shows the available amount.

Margin Level

The margin level defines the risk (a lower level is preferred).

By understanding how leverage works, you’ve already minimized the risk. Find out the leverage ratio that fits your trading style and design a proper money management plan to help you use leverage in a responsible way.

Pros and Cons of Leverage Trading

It’s important to understand the benefits and downsides so you can make a better-informed decision about buying on margin.

downsides Benefits

  • Minimal Capital Exposure:  The main advantage of leverage trading is the possibility to substantially increase the returns you obtain on an investment. It allows you to trade at a professional level with minimal capital exposure.
  • Profit Potential: With the right leverage ratio, a good strategy and a solid risk management plan, both beginner and experienced traders can savor the dreamed profits.

downsides Downsides

  • Your Trading Account can be Wiped Clean: If you’re not conscious of the severity of the risks posed by leverage and how easily it can backfire, it can turn into one of your most regrettable experiences.
  • Margin Calls: Just as leverage can move strongly in your favor, it can equally move against you when you call a position incorrectly. This is arguably the biggest disadvantage. In some cases, in order to ensure customer protection, certain financial authorities even limit the leverage. For example, in the United States, a 1:50 ratio is the norm.

The Bottom Line

Leverage trading is a common practice suitable for all asset types including stocks but it is heavily-used in Forex trading. Buying on margin provides you with the ability to bring you the rewards you’ve been dreaming of, whilst allowing you to manage a capital that exceeds your initial deposit. However, it can also work against you, especially if you’re a beginner to trading on margin.

To minimize the risks of leverage trading, pick a solid trading strategy, the appropriate leverage ratio and create a trading plan to follow that encompasses risk management techniques. When done right, leverage trading can be the key to your financial success.

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