Guide to Leverage

Leverage trading guide

What is Leverage Trading?

In financial circles, leverage is defined as the ability to control a large sum of money using very little of your own money, or sometimes even none at all. As such, leverage trading allows UK traders to open positions in the market that are much larger than their available capital. This is also referred to as margin trading.

Leverage is one of the major attractions of online financial assets trading. It essentially gives traders the opportunity to make profits out of the small price moves in the market.

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Leverage and Margin Explained

Leverage basically refers to the ratio between the position value and the investment needed, whereas Margin is the percentage of the position needed.

Leverage is always expressed in ratios. For instance, if you open a standard lot size trade in the market worth £100,000, for example, your broker may set aside £1,000 from your trading account to cover the trade. This would mean that you are leveraged 100:1. You are basically controlling £100,000 with only £1,000. If the market moves 1% in your favour, your position would now be worth £101,000. To put it into perspective, if you had to come up with the whole £100,000, you will have made a paltry 1% profit, or only £1,000. But you only had £1,000 and made a gain of £1,000; which effectively means that you just made a 100% profit on that tiny 1% market move.

This is the magic of leverage. Despite the benefits, it is always said that leverage is a double-edged sword. If the above move was against you, you would have lost your £1,000.

High leverage stock brokers will always require a minimum security deposit for each lot size traded. This is what is referred to as margin. It is essentially a ‘good faith deposit’ required to open a position in the market. Margin is usually expressed as a percentage. In the above example, the broker required £1,000 so as to allow for the opening of a £100,000 position in the market. The £1,000 is the margin amount, which means the broker offers a margin of 1%.

Apart from the margin required, you will always see other ‘margin’ terms on your trading account including:

  • Account Margin – This is the amount of capital in your trading account. It is your entire trading bankroll.
  • Used Margin – This is the amount of money your broker has set aside (or locked up) to cover your open trades. The money is still yours, but you cannot access it until you manually close the trades, or unfortunately, receive a margin call.
  • Usable Margin – This is the portion of your trading capital available for opening new trade positions in the market. It is basically your trading equity less used margin.

Margin Call Explained

This is the most dreaded ‘call’ among financial traders. It happens when your trading equity equals or falls below your used margin. It is essentially a notification from your broker that your margin for open trades is used up and you need to deposit or free more funds to keep your open position running. When a margin call occurs, the broker will close some or all of the open positions to prevent your account falling into a negative balance.

Take the example below:

Assume you open an AvaTrade forex trading account with a capital of £2,000. You now have a usable margin of £2,000. If you decide to open a trade with a margin requirement of £1,000, your used margin will now be £1,000, and your usable margin will become £1,000. Usable margin is the amount of money available to open new trades or to guard against trading losses. If, unfortunately of course, your trading losses exceed your usable margin of £1,000, you will get a margin call.

Where Leverage is Used

Nowadays, traders can use leverage in almost all financial asset classes. At AvaTrade UK, traders can use leverage on:

  • Forex
    AvaTrade UK traders have access of up to 400:1 leverage when trading their favourite major, minor or exotic currency pairs. Forex is the largest market in the world with daily trading turnover in excess of £6 trillion. Currency pairs usually do not make major moves compared to other asset classes, but a 400:1 leverage can amplify even the tiniest of moves and enable UK traders to boost their profitability immensely.
  • Stocks and Indices trading
    These are the oldest asset classes in the financial markets. Stocks and indices usually make big moves regularly and are very popular among online traders. A 10% move in individual stocks or indices is not uncommon. UK traders can even boost their profits even further by trading their favourite global stocks or indices with the 20:1 leverage that AvaTrade offers on these asset classes.
  • Commodities
    Commodities, such as gold, silver or crude oil, are well known for their big trending moves. It is why, traditionally, they were the preserve of ultra-wealthy individuals. But AvaTrade UK traders can join in on the action by trading lucrative commodities, even better with the up to 400:1 leverage available.
  • Cryptocurrencies
    Cryptocurrencies are the new trending asset class in financial markets. As typical with new assets, they tend to make big and, sometimes, erratic moves. For traders, this is a good thing because money is made out of price movements in the financial markets. AvaTrade UK traders can trade exciting Bitcoin and other digital coins and increase their potential profits using the 20:1 leverage on offer.

Why Trade with Leverage?

Leverage has become very common in the online financial trading world because of its many benefits. These include:

  • Leverage minimises the amount of capital a trader has to invest. You only pay a portion of the total position instead of paying the full amount. For instance – if a position’s value at the time of opening is £3,000; instead of paying the full amount, one can employ a leverage of 400:1 – meaning that for every £400 in actual value, the trader will be requested to invest £1 of their own capital. This means that for this position, the trader will need £7.5 to open the trade. Leverage helps investors free up capital that can be committed to other investment opportunities.
  • Leverage amplifies potential profits. For a fraction of the value of your trade, you receive the same profit as in a standard trade. Profits are calculated using the full value of your position, which means that leverage magnifies your profits on successful trades.
  • Leverage mitigates the effects of low volatility. As stated earlier, money in financial markets is made out of price movement. But in some cases, volatility is low, implying that there is low price movement and thus, low profit opportunity. But leverage ensures that even the tiniest of moves in the market can deliver substantial profits. You can adjust your trading leverage accordingly and make money during all market cycles.

Disadvantages of Leverage

Despite the great benefits of leverage trading, here are some of its disadvantages you should consider:

  • Leverage is a double-edged sword. Just as it amplifies your profits on successful trades, you stand to lose big on your unsuccessful trades.
  • On highly volatile markets, a losing streak can make a significant dent in your trading capital.

How to Use Leverage Effectively

As discussed above, leverage has great benefits, but it can also be a monster. When used effectively though, leverage can help traders maximise profitability when trading online financial assets. The effective use of leverage entirely relates to trade size and account equity, as well as risk tolerance. You should vary you trade size according to your risk tolerance so as not to create significant damage to your account equity. Your trade size determines your potential gain or loss in any particular position you open in the market. The optimal trade size will always depend on your account equity and risk tolerance.

Traders are always advised not to stake more than 10% of their trading capital on any single trade. For instance, if you have £10,000 in your trading account, you should not stake more than £1,000 on any single trade. To ensure you do not exceed this limit, and never leave yourself exposed to the dangers of leverage, you should use stop loss orders on all your trades. A stop loss is an order that automatically closes your trade at a pre-set price point. This effectively limits your losses when a trade goes against you. For instance, if you open a 1 lot (1 pip equals £10) EURUSD long trade at 1.1500 and wish to risk no more than £1,000, your stop loss will be set 100 pips away at 1.1400. If you vary your trade size and decide to trade 2 lots (where 1 pip equals £20), it would mean that you will now place your stop loss order 50 pips away at 1.1450.

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. You can enjoy up to 400:1 leverage on MetaTrader4 (MT4). Most forex pairs have the highest leverage; some metals, such as gold, are 400:1, crude oil is 200:1 and other metals, such as silver and platinum, have a 200:1 leverage. It is important to check the leverage on the specific platform you are using 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 uninterrupted.

Leverage trading with AvaTrade also has other benefits for UK traders such as:

  • Guaranteed Stops
    Guaranteed stops work the same way as standard stops but will always be triggered at the exact price point that you set, regardless of whether price gaps or slippages occurred. This means that you will always be protected if a trade moves against you.
  • Negative Balance Protection
    UK AvaTrade traders cannot lose more than their total equity available in their account. Leverage can amplify your losses when trades go against you. But unlike other brokers where you can lose more than your trading capital and be required to compensate your broker, this will never happen at AvaTrade.
  • Real-time Risk Exposure Monitoring
    UK traders can monitor their leverage risk exposure in real time across all AvaTrade platforms. When your trades are running, AvaTrade relays your overall risk exposure in real time so you can always know which trades are exposing you to leverage risk, so you can adjust them accordingly.
  • No Changes in Margin
    When you leave your trades running overnight or during weekends, AvaTrade will not adjust your margin in any manner. This means that there will be no additional leverage risk for traders that apply long term trading strategies in the market.

Want to enjoy the great benefits of leverage, while using the best risk management tools? Sign up at AvaTrade today and start amplifying your profits!