Every investor dreams of earning their first million but the vast majority only have small amounts of money to trade with, comparatively speaking. However, there is a way to increase potential profits in trading and that is by leverage. But whilst the advantages can be very seductive leverage must be used with extreme caution because it can also lead to heavy losses in inexperienced hands.
When they enter the market for the first time, many traders do not have more than a few thousand pounds at most to trade with. As expert opinion suggests a trade should not be opened with more than 3-5% of your total account balance, it's easy to see why it can take some time to make a profit, even if you manage to pull off a winning position.
Leverage is basically another word for debt. Leverage is the tool offered by brokers that allows traders to become more effective in the market without having to shell out the money upfront. It essentially means that investors are able to 'borrow' money from their broker in order to place larger trades. Leverage is offered as a ratio; the higher the ratio the more potential profit can be made.
Many traders deliberately seek out brokers willing to offer higher amounts of leverage and whilst there is no denying this can bring faster rewards, it is a double-edged sword as it can also bring an account crashing down.
If you want to use leverage to trade, you must appreciate that you cannot have your cake and eat it! If you want the possible advantage of larger profits from an enhanced trade value, there is always the risk you will end up having to swallow amplified losses too. If you are trading with leverage that is too high, it only takes one loss to wipe out your account completely.
Different markets operate leverage in varying degrees with some using it far more than others. For example, foreign currency trading, also known as forex, often employs leverage up to 1:400, a risky approach without question, but one that is widely available.
A broker will usually require the trader to keep a minimum level in their account, known as the margin. In other words, they will only extend credit based on the amount held in the account, which is a way of ensuring they can recoup any losses. If, for any reason, the trade starts to go wrong and you want to hang on in there and you have exceeded your leverage, you will have to deposit more money in your account, even though you are not increasing the amount you have invested. This is because the broker stipulates a minimum percentage must be held. Failure to deposit more money would result in the trade being automatically closed by the broker and you would be forced to swallow the losses.
So we can say that spread trading is highly 'geared'. Gearing means that in order to make any given profit from spread trading, you will need less capital than if you were to actually buy sufficient shares to have made that same profit. Let's look at an example where we compare buying shares versus spread trading:
For the purpose of this exercise we will ignore spreads and costs.
You buy 1000 shares at £5.00 = £5,000 of capital
The shares go up to £5.30 and you sell for £5,300
You make 1000 shares x 30p = £300 profit (6% return on capital)
You use £5,000 of margin
You can place £50 per point bet on the share using all margin
The shares go up from £5.00 to £5.30 and you close your bet
You make 30 points x £50 = £1,500 (30% return on capital)
So you can make your capital work MUCH harder for you by spread trading than you can by buying and selling shares.
However, just because a broker offers leverage does not mean you have to use it, or that you have to use the whole amount. Leverage is a concept that applies outside the trading markets and this is perhaps the easiest way to demonstrate the concept. A mortgage can be considered as a type of leverage as the individual is borrowing money against their salary to make an investment.
The mortgage company will decide how much leverage an individual can have, which is usually around three times their salary. However, just because a lender is prepared to extend that much credit does not mean you have to borrow the whole amount. If you find a cheaper house, you borrow less than the maximum available. The same concept applies when it comes to investments in the finance market.
Using the same example of a mortgage, if the property fell in value, you would still owe the lender the whole amount you borrowed, even though you had made a loss. Conversely, if the property rose in price, you would get to keep the profits.
Used wisely, leverage is an incredibly useful tool and one that can help to grow profits far more quickly. But beginners especially should not get carried away by generous offers from brokers, as it could spell a rather abrupt end to trading unless you are fortunate enough to be blessed with extremely deep pockets.
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