What is leverage
Leverage is a loan that a broker provides to you so that you can buy assets in excess of the size of your current deposit on an account on a broker’s platform.
It should be distinguished, the loan provided by the broker from a bank loan.
Banks provide people with real money that can be withdrawn from a bank account, you can buy various things. A loan provided by a broker, whether it is a Forex broker or a stock market broker, gives you the opportunity to complete a transaction, that is, open a lot using credit money. You cannot withdraw money yourself. The broker does not give real money to traders. It just provides an opportunity to buy assets for larger money than is in your account.
At the same time, the broker does not lose anything and does not bear risks. By making a transaction on the broker’s credit funds, you buy an asset, whether it is stocks, goods or currency. The asset you purchased becomes a guarantee of securing obligations with a broker.
If the price of an asset bought with credit money begins to fall, then the broker automatically sells this asset after notification and retains the money for its sale, and the trader loses all his money in the account.
Thus, in order to take advantage of leverage, it is necessary that a certain amount of money be in the account of the trader and it must be in the account constantly. This amount of money is a guarantee in the event of a situation when the price of an asset bought with credit money begins to fall, that is, the asset depreciates.
If the amount of the collateral is not enough, then to ensure obligations on the loan, the broker sells the pledged asset. In this situation, the trader loses money on the deposit. When the price of a pledged asset is reduced, the broker notifies the trader in advance of the price reduction. A trader can sell the asset at a loss and pay debts to the broker or add a deposit so that the broker does not sell the pledged asset automatically. In this case, the trader will lose all the money in the account.
Leverage allows you to conclude transactions for larger amounts than are on your trading account. Leverage is necessary in order to buy an asset, the price of which rises sharply or, conversely, drops sharply.
If the price shows active growth, then taking a leverage, the trader can buy more assets at a lower price. Wait until the price of the asset reaches its maximum, sell the asset at a higher price, return the loan money to the broker, and leave the difference between the purchase and sale minus the commissions to the broker.
Thanks to leverage, a trader can buy 10 or even 100 units of a position, while on his own without a loan, he could buy only 1 unit of a position. Thus, in the case of an increase in the price of an asset by selling it at a higher price, the trader will receive a profit from 10 or 100 units, and not from one unit of the asset.
Also, a trader can make money in the event of a sharp drop in the price of an asset. This is done as follows. A trader, using leverage, at the beginning of the fall in the price of an asset, buys the given asset, immediately sells it, while the price of the asset is maximum. The trader has money left in his account. Further, the trader waits until the price of the asset drops as much as possible and at the minimum price buys the same amount of assets that he sold and returns to the broker the assets bought on credit. The difference between buying and selling, minus the broker’s commissions, he leaves to himself.
Thus, it is recommended to use leverage in a situation where the price of an asset drops or rises sharply, that is, during periods of strong and preferably long-term price changes in a certain direction. Do not forget about paying commissions to the broker, therefore, the amount of profit from rising or falling prices should exceed the amount of commissions.
Whether it is worth taking a leverage or not, each trader decides for himself. Many people have a negative attitude towards loans, and even such a thing as credit slavery has appeared. This concept applies only to bank loans. This concept has nothing to do with broker loans, since you do not receive real money using the leverage. If a trader will trade with leverage, under no circumstances will he fall into credit slavery, as real money is not given.
Leverage is the ability to enter into transactions for larger amounts than are on your trading account. In case of failure, you will lose all the money in your trading account, but you will not become a debtor to the broker.
Leverage is provided only if there is money in the trader’s accounts. The more money is in the trader’s accounts, the greater the amount of leverage he can use, and, in case of failure, the greater the amount the trader can lose.
Many traders are afraid to trade with leverage, since such trading carries great risks and the trader may lose his deposit. This is especially dangerous when a significant amount of funds is on deposit and the leverage is very large.
Trading without leverage does not have the same risks as with leverage, since in this case you only risk your own funds. But without leverage, you cannot earn as much money as you could earn with leverage. It will be very difficult for you to increase your deposit, since the size of your current deposit will not allow you to make transactions in large amounts.
Trading without leverage, you can, if necessary, withdraw your money from your trading account at any time. If you use leverage, the amount of your deposit is pledged by a broker and you cannot withdraw your money from your account.
Leverage is necessary so that having a modest deposit can increase it in a short time, albeit with higher risks. It makes sense to use leverage only if you are confident in your market forecasts. If for any asset there is a clearly directed price movement. And it does not matter in which direction the price changes: up or down. The main thing is that it be a one-way traffic.
The price change must be significant so that the amount of your profit from using leverage exceeds the amount of broker commissions.
Leverage in simple words
Leverage allows you to make transactions for larger amounts than are in your account. At the same time, assets bought for credit money are pledged by a broker. If the price of an asset starts to fall and the amount of collateral is not enough, the broker informs the trader about it. A trader can sell assets, thereby fixing their losses and paying the broker. In this case, the trader will lose part of his deposit. Also, the trader can increase the size of the deposit, that is, invest additional funds in the account to increase the amount of collateral and get a chance to wait until the price of the pledged asset rises.
In addition to providing the purchased asset for leverage, additional security is required in the form of a deposit on the trading account in the event of a fall in the price of the pledged asset.
The broker receives a commission on trade turnover. Leverage is necessary in order for a trader to buy as many assets as possible, that is, increase his turnover.
Thus, if a trader takes advantage of leverage, he will pay much higher commissions due to increasing turnover, and this is very beneficial for the broker.
But the fact that it is beneficial for a broker who does not risk anything when providing leverage is not necessarily beneficial for a trader who, in case of using leverage, risks his entire deposit. Do not forget about it.
What leverage to choose
Different brokers offer different leverage sizes. The maximum leverage is usually 1: 200. This means that with your own deposit of $ 1,000, you can make a deal of $ 200,000.
There is a golden rule of diversification. The size of one transaction should be about 2% of your total trading portfolio. That is, to make a deal of $ 200,000 your trading portfolio must be $ 10,000,000. Under such conditions, you make your risks minimal.
Another thing is that it is rare when traders remember these rules. Even if they remember them, they are not used, since they do not have a trading portfolio of $ 10,000,000.
It is rare that a trader uses a leverage of 1: 200. Typically, traders use a leverage of 1: 2 – 1: 5.
Different assets behave differently. So, we know that the US dollar is considered one of the most stable assets, but even this asset depreciates over time. On the other hand, the price of cryptocurrencies per day can vary by 50%, sometimes even higher. Therefore, brokers, if they give leverage on cryptocurrencies, then no more than 1: 3. If someone gives you a leverage on cryptocurrencies of 1: 200, this is clearly a scam.
Do not forget that a high leverage is a legitimate opportunity for a broker to pick up a trader’s deposit. An exchange broker does not risk anything, since an asset bought on a leverage is pledged by a broker. In addition, the deposit of the trader is also in the pledge of the broker. This is done in order to ensure the safety of the broker’s funds in the event of a fall in the price of a pledged asset.
If you trade using leverage, then you cannot withdraw your deposit. This allows brokers to constantly store the funds of traders in their accounts and use them in their interests.
This is another reason why it is beneficial for brokers to provide traders with the highest possible leverage.
The specific amount of leverage depends on:
- Market sentiment
- From the direction of price movement for a specific asset,
- From the number of open positions,
- From the experience of the trader and his confidence in the rise or fall of the price of an asset,
- Of the total size of the trader’s investment basket,
- The size of his deposit on the trading account,
- Of the amount of available funds in the trader’s circulation.
Which leverage is better
When choosing the size of leverage, you must pay attention to the following:
- Stability of an asset secured by leverage,
- Number of assets, not forgetting about diversification,
- Trade deposit amount,
- Ratio of deposit to leverage.
When trading using leverage, it is recommended to set a stop loss. This function allows you to record losses so that in case of failure, lose only part of your deposit, and not the entire deposit. The fact is, if you do not install this function, then in the event of a fall in the price of assets secured by a pledge, you may lose the entire deposit.
Remember that leverage gives a legitimate opportunity for a broker to withdraw your deposit. While using leverage, your deposit is pledged by the broker, that is, you cannot withdraw it, and the broker can use it at his discretion.
The higher the amount of leverage, the greater should be the size of the deposit providing it.
You cannot use leverage only for the purchase of one asset. There must be diversification. If you lose funds on one asset, you can return at the expense of another.
The more stable the asset, the greater the size of leverage. For example, cryptocurrency prices are extremely unstable and can rise or fall during the day with great fluctuation in different directions. If you set a stop loss on cryptocurrencies using a large leverage, this will lead to the fact that with the slightest decrease in the price, the stop loss mechanism will work and you will lose your money to pay off the broker.
Also, do not forget, the larger the leverage, the greater the volume of the transaction, the higher the commission of the broker. You risk your entire deposit, and the broker does not risk anything, while receiving increased commissions due to the large volumes of transactions.
It is very beneficial for brokers to impose maximum leverage on you so that your trading volumes increase sharply. Use leverage only if you are confident in your strategy and the market for this asset behaves predictably.
Using leverage is a great chance for a trader to disperse the size of his trading deposit, without investing his own funds. If you do not have free cash to invest in a broker account, and you want to earn more and live better, then leverage provides you with excellent chances for development and trading. Thanks to leverage, you can achieve great results and improve your life. However, you will not fall into credit slavery, as is the case with banks. Exchange brokers, unlike banks, do not provide real money. They only make it possible to trade in large amounts than there is in your account and earn more money.
At the same time, the broker does not risk anything, and you risk your deposit. Your deposit is frozen, you cannot withdraw it, that is, your money is actually at the broker’s disposal. At the same time, the broker earns increased commissions due to the large volume of trades. Indeed, using large sizes of leverage, the trader begins to trade in large volumes.
If a trader uses a leverage of 1: 200, this means that he concludes a deal 200 times more in volume than the size of his current deposit, which also means that the trader will pay a commission to the broker 200 times more due to the increased volume of turnover .
Now you understand how beneficial it is for a broker to provide leverage to traders.
It is not surprising that brokers offer various stocks and sometimes the size of the leverage simply goes through the roof. People love promotions, bonuses and freebies.
Just do not forget that leverage is not a freebie, this is not a bonus – it is a trading tool. Do not forget about the size of commissions, which will increase in proportion to the size of your leverage.