What is leveraged trading? In this post, we find out!
Before we get into it, it is important that we mention that this post does not constitute financial advice and is merely educational in nature. Leverage trading is extremely risky and you can lose more money than you initially invested, forcing you to pay back additional money to your broker out of pocket.
Our goal with this post is to give you a solid foundational understanding of what leverage trading is so that you can more easily further your own understanding down the road.
Leveraged trading is often times also referred to as trading on margin. This means that you are borrowing money, usually from a broker or exchange, at a pre-determined amount and using that to invest with. To be able to do this though, you have to deposit a pre-specified amount with your broker and then they will loan you more money. This is called the initial margin.
There are specific exchanges that will allow you to trade with leverage.
For example, let’s say you have $100 and so you deposit this with your broker. This is your initial margin. If you want to achieve 10X leverage, your broker would give you $1,000 to invest ($100 X 10 = $1,000). At the end of your investing period, you have to return the $1,000 to your broker and an additional fee for him lending you the money. However, any returns that you made with the $1,000 is yours to keep. You also get your own $100 of initial margin back.
Why would you want to do that though?
The answer is to increase your returns, dramatically. We will give you a step by step example of how it works further on in the post.
This isn’t without a lot of risk, though. While leverage trading can boost your returns 5, 10, 25, 50, and even 100 times in some cases it can also boost your losses in the same amount. Think about it like this: The bigger you are, the harder you fall.
Leverage trading should only be done by experienced investors because you can easily lose more than you initially invested and thus be forced to pay more money than your initial margin amount to your broker to make them whole.
The use of leverage is significant because it essentially lets you invest more money than you currently have. Because you are investing more money than you currently have, your profits will be bigger. A 1.5% return on a $100 is a $1.5. However, if we employ 100x leverage that same 1.5% increase now results in a $150 profit because we effectively turned our $100 into $10,000 and that $10,000 increased to $10,150. After returning the original amount of $10,000 back to your broker (ignoring any fees), you keep the profits, or $150.
Leverage trading allows a small percentage move in the underlying price of an asset to translate to a large percentage move in your profit & losses.
How does this work? Let’s take a look at an example below
In the example above, you can see that when you employ leverage, your returns are boosted to the amount of leverage. So if you are levering up 100:1, your returns (AND LOSSES) will be a 100 times greater.
For experienced investors who want to employ less of their own capital, leverage trading is a great way to keep up with the bigger fish. It’s important to do it safely however, as the example above illustrates you can lose more money than you initially deposited!
The more leverage you employ, the larger the swings are in price. Assuming 100X leverage, a .15% decrease in price is now a 15% decrease in price.
If you have any questions regarding this explanation please feel free to contact us at firstname.lastname@example.org where we will be more than happy to assist you!
Thank you for reading!