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What is Leverage In Trading?
Leverage is used to increase a traders trading position in the market than the capital invested. A mechanism to greater exposure in the market with less amount.
Leverage is the mechanism that gives the trader exposure to the trading market with an initial amount deposited by the investor. However, the exposure provided by leverage is more and offers a high trading position than the amount deposited. Leverage could be in any product like CFDs, Stocks and Commodities etc.
It is a powerful tool in trading online to take advantage of the price movements of the instruments. The percentage of credit given by the broker helps in paying the value of the transaction. Leverage is in rate or ratios like 1:200,1:300 or 1:500. There are various leverage values per the trade, and brokers also have their set leverage offered for the investors.
The formula of marginal leverage equals total transaction value divided by the margin required.
For real leverage, the total value of translation is divided by total trading capital.
So, through these formulas, an investor can get the leverage rate/ratio.
Forex markets generally have a high leverage ratio of 100:1. This is because leverage gives traders increased value; for example, a trader owns 1500 funds, so the value the trader would be able to trade is 15,00,000. So it doubles the trading position of the investor. But with high leverage comes the high risk. However, these risks could be minimised with proper management of the account of forex trading.
In trading, the brokers provide this leverage as they get benefited in return. If a trader opens with a high position, then the broker applies the commission or fee charges. But, as we discussed, the risks are also high, making for more mistakes, and brokers are benefited in double. So, a trader must be careful about the leverage offered by the broker and the capacity of trading of the trader.
Other than this with leverage, there are overnight fees charged. These are the costs for lent funds for opening a trade. But, again, this calculation depends on the broker's method, which could be costly for the investor.
How To Trade In Leverage?
Trading with leverage is quite risky, so an investor with professional experience and patience should calculate the leverage and trade. The high position attracts many investors, but the trader should think and decide before trading with such high leverage. The trader must have the following points in mind:
- Risk management strategy
- Average movement of the instrument
- Capital of trading
- Bearing power of investor
- Price movement
Leverage should be traded not just for opening high but for-profits, and if the risk is high, a trader must think before investing. The trader should calculate the leverage and other factors well. Then, for knowing the profit and loss of trade, the trader can multiply the quantity of the shares/commodities with the price change and get profit/loss incurred.
The process is simple, but the risks of leverage are high. For beginners, it would be a difficult term to understand and trade. They must first practise through demo accounts or take the help of professionals to earn and securely trade without the fear of high loss.
Leverage in Stock Market
For stock market traders, the leverage operation is the same as any other market, but shares have some particular terms that should be known while trading in the stock market using leverage.
Buying power: The capital or fund available to the investor to purchase the shares or securities in the market. It should be higher to manage the risks of leverage.
Risk ratio: The risk ratio is used to indicate the risk that could occur due to the investment. Representing the ratio of the net balance to the leverage amount, it reflects the amount which will be paid due to the risk.
Leverage in the stock market gives traders buying power with the leverage. Futures contracts and options are a good example for leverage, where there are high leverages. In this, a marginal value is paid to the broker for trading.
Speculation is a significant part of stock trading; if the speculation is correct, then the trader benefits, but if it goes wrong, then losses may occur. With SEBI’s list of stocks, a trader can know stocks with the leverage rate. The trader needs to have a marginal amount in the account to trade with leverage. Other than this, stop-loss and risks should be calculated adequately by the holder of shares.
Similarly, leverage is used in CFDs, Commodities, Cryptocurrencies and Indices etc.
Advantages and Disadvantages
Loan: Leverage is a type of loan which the broker provides the investor. It is a loan with no interest or commission on it, benefitting the trader with no extra charge and could be utilised as per choice.
Capital: Leverage is a good source of enhancing the capital and position in the trading market. As the leverage ratio gives a high position to traders with less capital invested. So, taking in less capital and increasing the profits.
Less Volatile market: The market is uncertain and could be the reason for both high profits or high losses. As the prices change in high or low, traders prefer a highly volatile market due to large benefits. But with low leverage also the trader can earn gains, and the volatile market nature does not affect it much.
Risk: However, the risk of trading with leverage is relatively high. The brokers earn out of the leverage and charge fees and commission. The loss gets doubled with high leverage making it risky for traders. This is the primary leverage point, making it worth thinking before going for a high leverage ratio.
Leverage is a risky ratio to trade with. A trader who is ready to go broke can enjoy high leverage. As the market is volatile, the high leverage can act as a profit or loss. However, it opens with a high position in the market, giving it a plus point. A trader can go for leverage but keeping in the situation, instrument of trade and financial position. Traders should analyse before investing and use tools and platforms to have profits with high leverage.
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