Guide to Leverage
What is Leverage Trading?
Leverage trading, also known as margin trading, is a system which allows the trader to open positions much larger than his own capital. The trader needs only to invest a certain percentage of the position, which is affected by many factors and changes between instruments, brokers and platforms. Leverage trading is popular amongst traders and brokers, and is a common trading system nowadays. “Leverage” usually refers to the ratio between the position value and the investment needed, and “Margin” is the percentage of the position needed.
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Why Trade with Leverage
There are several advantages to trading with leverage, so much that is has become a common tool in the trading world.
- Minimizes the capital the trader has to invest. Instead of paying the full price for an instrument, the trader can pay only a small portion of it. for instance – if a position’s value at the time of opening is $3,000; instead of paying the full amount, he can employ a leverage of 400:1 – meaning for every $400 in actual value he will be requested to invest $1 of his own capital. This mean that for this position he will need $7.5 to open it.
- Some instruments are relatively cheap, meaning almost every trader can trade them easily. However, some are considered more prestigious, and based on their traded frequency and other factors are more expensive. Instead of investing large amounts in order to take part in their market, one can use leverage and enjoy the fluctuations in the price of those prestigious instruments.
- While leverage trading, or margin trading, has less capital involved which can be a major advantage for many traders, it also comes with a loss risk. As one can gain much more than his initial investment, losses can occur on the same scale. It is important to keep track of opened positions, and apply stop loss and other market orders in order to prevent large scale losses.
Example of Leverage Trading – Retail Clients
For example, the price for one Troy ounce of Gold is $1,327. The trader believes the price is going rise and wishes to open a large buying position for 10 units. The full price for this position will be $13,270, which is not only a large amount to risk, but many traders do not possess such amounts.
With a 20:1 leverage offered by AvaTrade, or a 5.00% margin, the amount will decrease substantially. Meaning that for every $20 of worth in the position, the trader will need to invest $1 out of his account, which comes to $663.5 only.
When we decide to open a trading position, we first need to know what’s the applied margin, define a target, and define a maximum loss with a stop loss which will automatically decide our position in order to prevent losses by automatically closing the position.
It is possible to define very easy risk management rules in order to avoid being negatively surprised by the leverage mechanism – notably, never risking more than 5% of your capital in a single operation.
How to choose the best leverage?
Choosing a suitable leverage depends on many factors. First and foremost, it depends on your money, but also on your capacity to manage risks, and your chosen trading style. If you trade on a short-term basis, your perspectives of gains are not very high. With scalping, traders’ gain targets are usually between 5 to 10 pips. As follows, in order to obtain maximum gains, it is necessary to use a large leverage. On the contrary, if the scope of your investment is rather long-term, for example in stocks, it is recommended to use a rather weak leverage in order to make sure that contrary movements on the market cannot eat up all of your invested money. To simplify and sum up what is important, in order to choose the best leverage, you have to study the volatility and define your investment period. Discover Avatrade’s demo account and enjoy free access to trading platforms with virtual money. In this way you’ll be able to trade and check your tests before investing any of your real money.
Losses higher than your deposits?
If you choose to use leveraging, it is important to understand that this can lead to losses higher than your capital in certain market situations. In fact, the increase in the size of your position thanks to the effect of leveraging will allow you to multiply your potential gains, but also your potential losses. In case you don’t have any more funds available, you can’t open any further financial positions. In such a case you’ll be able to choose to either fund your account in order to increase your available funds, or to close a part of your positions in order to decrease the need of coverage. If your open positions progress in the wrong direction, you may find yourself in a situation when your required coverage is higher than your current account balance and your available funds are negative. Such a situation will lead to a “margin call” from your financial intermediary who will ask you to either add funds or to clear a part of your positions. In case your situation isn’t re-established quickly, your intermediary will have the power to close all or a part of your positions by himself. In case of a violent movement (notably a gap), it is possible that yout intermediary is not capable of closing your position. In that case, you may end up with a negative account balance.
Dangers and disadvantages of Excessive Leverage
This is where the double-edged sword comes in, as real leverage has the potential to enlarge your profits or losses by the same magnitude. The greater the amount of leverage on the capital you apply, the higher the risk that you will assume. Note that this risk is not necessarily related to margin-based leverage although it can influence if a trader is not careful. Let’s illustrate this point with an example. Both Trader A and Trader B have a trading capital of US$10,000, and they trade with a broker that requires a 1% margin deposit. After doing some analysis, both of them agree that USD/JPY is hitting a top and should fall in value. Therefore, both of them short the USD/JPY at 120. Trader A chooses to apply 50 times real leverage on this trade by shorting US$500,000 worth of USD/JPY (50 x $10,000) based on their $10,000 trading capital. Because USD/JPY stands at 120, one pip of USD/JPY for one standard lot is worth approximately US$8.30, so one pip of USD/JPY for five standard lots is worth approximately US$41.50. If USD/JPY rises to 121, Trader A will lose 100 pips on this trade, which is equivalent to a loss of US$4,150. This single loss will represent a whopping 41.5% of their total trading capital.
The interest of using leverage
1. One significant advantage is that an appropriate usage of leverage allows the trader to avoid immobilizing all of his money on a trading account and instead to place the remaining part for example on an interest-bearing account. Not depositing the whole of your trading capital into your account can also be part of your risk management strategies.
2. Leveraging is mainly useful for adapting one’s risk taking in regard to the volatility of the market on which one is trading. Adjusting the leverage allows the trader to work with a constant range of risk, regardless of the volatility of the market.
On a market with low volatility, the trader can choose to artificially increase his position sizes thanks to leveraging in order to benefit from low level of variation. On the contrary, in the case of high volatility, the trader will choose to decrease the leverage utilized in order to decrease his exposure to the market.
Margin Call – Retail Clients
In order to employ leverage, one needs to have sufficient funds in his account to cover possible losses. Each broker has different requirements, and AvaTrade requires a Retail Trader to possess Equity of at least 50% of his Used Margin for MetaTrader 4 and AvaOptions accounts. Going back to the example above, the position’s original value is $13,270; for both MetaTrader 4 and FX options trading accounts, with leverage the trader invested $663.5 of his capital, and if he has 50% of this used margin in equity, i.e. $331.75, his positions will be kept opened. If, however, the trader has losses and his Equity drops below 50% of used margin on MetaTrader 4 and AvaOptions accounts, the broker will shut down the client’s position(s), which is called a “Margin Call”. On AvaOptions all the client’s positions will be closed, while MetaTrader 4 will shut down the largest losing position first, and will continue to close positions until the equity level returns above 50% of the used margin.
Example of Leverage Trading – Pro/Non – EU clients
For example, the price for one Troy ounce of Gold is $1,327. The trader believes the price is going rise and wishes to open a large buying position for 10 units. The full price for this position will be $13,270, which is not only a large amount to risk, but many traders do not possess such amounts. With a 200:1 leverage offered by AvaTrade, or a 0.50% margin, the amount will decrease substantially. Meaning that for every $200 of worth in the position, the trader will need to invest $1 out of his account, which comes to $66.35 only.
Margin Call – Pro/Non – EU clients
In order to employ leverage, one needs to have sufficient funds in his account to cover possible losses. Each broker has different requirements, and AvaTrade requires a Pro/Non – EU Trader to possess Equity of at least 10% of his Used Margin for MetaTrader 4 and AvaOptions accounts. Going back to the example above, the position’s original value is $13,270; for both MetaTrader 4 and FX options trading accounts, with leverage the trader invested $66.35 of his capital, and if he has 10% of this used margin in equity, i.e. $6.64, his positions will be kept opened. If, however, the trader has losses and his Equity drops below 10% of used margin on MetaTrader 4 and AvaOptions accounts, the broker will shut down the client’s position(s), which is called a “Margin Call”. On AvaOptions all the client’s positions will be closed, while MetaTrader 4 will shut down the largest losing position first, and will continue to close positions until the equity level returns above 10% of the used margin.
Leverage Trading with AvaTrade
AvaTrade offers many instruments, and each has a different leverage which can also change based on the chosen platform by the trader. On MetaTrader4 and MetaTrader 5 you can enjoy an up to leverage. Most forex pairs have the highest leverage, some metals such as gold are , crude oil trading as well as silver trading and other metals is limited to leverage. It is important to make sure the leverage on the specific platform before you commence you trades, and in order to avoid a margin call always make sure you have enough equity in your account’s balance so you can continue your trades undisturbed.
How to start?
How to do it in practice? To trade online using CFD contracts, it is first necessary to open a trading account with Ava Trade and deposit a minimum of 100 euros.
One of the best brokers in CFD regulated in France is Avatrade. Avatrade has a highly performing CFD and Forex platform which allows you to trade more than 250 instruments with a single trading account. A CFD trading account opened with Avatrade is not a custody account nor a PEA because CFD transactions are not closed by transfers of securities.
Hence, we cannot really speak of buying or selling in the case of CFD contracts. In fact, you are not really buying assets, rather, you are trading on their difference, as suggested by their name.
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