Leverage trading should be known to traders more than investors. Leverage is a great tool for traders who like to profit from frequent market movements. Leverage trading and Margin trading is one or the other same and used interchangeably.
In this article, tradingcritique.com explains leverage trading in a more understandable way. Usage of margin trading in the article also represents the same meaning as leverage trading.
If you are a beginner at trading and its concepts, we recommend you to read our article on Trading – All you need to know about, where you can understand most of the basics of trading.
What does the word leverage mean?
The Oxford Learners Dictionaries gives the meaning of leverages as “the act of using a lever to open or lift something; the force used to do this”.
Merriam-Webster.com gives the meaning of leverage as “the action of a lever or the mechanical advantage gained by it”.
Merriam-Webster.com also provides other meanings which apply to this content of leverage trading namely,
The meanings given above can provide you with a basic idea of what leverage means. Use this understanding and apply it to leverage trading that will be explained in the next section.
Understanding Leverage vs Margin Trading
You borrow money from the Broker-Dealer/service provider to execute your trades in leverage trading. You make an initial payment to the service provider called Margin to open a leverage position in trading. Leverage trading can also be called Margin trading.
You may not have sufficient funds to execute a trade. In that case, you borrow money from the service provider by providing a margin for the trade and execute it.
The profit or loss incurred for that complete trade belongs to you. The margin here is the investment you make for leverage trade. If your trade moves in a negative direction you may need to pay more margin to continue with the trade.
Now you can relate with the meanings given in the above section for leverage.
The borrowed money acts as leverage for your trade to increase your profits.
But leverage trading should be handled with caution. You should know the complete process and nuances behind leverage trading before starting one. By knowing leverage trading properly, you can gain profit, on the other hand, when you enter into leverage trading without knowing about it you can incur losses that you cannot afford. You may lose all your investment in one leverage trading order.
Completely educate yourself and practice yourself by using leveraged positions with utmost caution. You can expertise in margin trading only on consistent practice.
Regulations for Leverage Trading
As normal trading, regulatory bodies of various countries regulate leverage trading also. Such as the SEC in the USA and FINRA in the UK, CySEC in Cyprus, FSC in Mauritius, etc.
These Regulatory bodies provide special schemes like Negative Balance Protection especially for leverage trades as this kind of trades can make traders lose more money. So, more protection and regulations are followed for margin trading.
Choose only the regulated Broker-Dealer platforms to place leverage trades or else you may lose more than your invested money. Do leverage trading only if you completely know about it.
Who can do leverage trading?
As a beginner starting directly with leverage trading may not be a proper way. Experience more with normal trades. Gain confidence and earn profits in normal trades. Then try leverage trading.
Start your leverage trading with a lower leverage ratio such as 10:1. Practice consistently. Leverage trading is a skill and develops as you practise. Sometime soon you can also be an expert.
Many experts in trading use leverage so wisely to earn great profits. Those experts too started their trading journey as a beginner. So keep on trying and grow at each level to become an expert in leverage trading.
The process behind leverage trading
Leveraged trading is provided by trading platforms such as the Broker-Dealer platforms. They mostly avail leverage trading at an extra service cost/charge/commission.
Mostly leverage trading is available in derivatives trading and over-the-counter trades. Margin trading is used prominently in futures, options, forwards, CFDs, and other derivatives. Margin trading is most famous in Forex markets or currency trades.
In leverage trading, you need to understand two things clearly. One is the Total transaction value and the other is the Margin cost.
The other important things in Leverage trading are,
1.Total Transaction Value and Margin Cost
Total transaction value is the complete amount for which you open your leverage trade. Margin is the initial deposit you paid for the leverage trading. The margin you provide for the leverage trading can also be called trading capital.
Margin is a part of the Total transaction value. It is the amount you pay for any leveraged trade and the remaining amount of the Total transaction value is borrowed from the service provider.
For example, to open a trade worth £1000 you pay a margin of £10. Here £1000 is the Total transaction value of this leverage trade.
2.How is margin determined?
The margin differs for each and every leverage trading. The service provider decides the margin for a specific leverage trading.
Margin is either given in ratio or percentage considering the Total Transaction Value.
For example, a margin of 10% is required. If the Total Transaction Value is £3000, the 10% margin could be £300. To open this leveraged trade you need to pay £300. When you express this in a ratio of Total Transaction Value: Margin, margin-based leverage is obtained. The margin-based leverage to this trade is 10:1. For this same example 20:1 has the same margin of £300 but the total transaction cost will increase £6000.
The leverage ratios provided by the Broker platforms are basically like 10:1, 20:1, 50:1, 100:1, 200:1, etc. These ratios are called leverage ratios.
For each and every trade this margin percentage differs according to the Total Transaction Value. Your profit and loss in a leveraged trade are determined by the margin and the Total Transaction Value.
3.Determining Profit and Loss in leverage trade
Determining the profit and loss before entering into any leveraged trade is a good practice. This helps you to reduce your losses and maximize your profits in that leverage trade.
The profits and losses for normal trades and leverage trades are different.
For example, if the Total Transaction Value of a trade is £100, in a normal trade your initial investment is the Total Transaction Cost i.e. £100. But in leveraged trade your initial investment is the margin, say 10% margin for this trade, then your initial investment is just £10.
In this trade, if the market moves in a positive direction and your trade value raises to £200. In a normal trade you get 100% profit i.e., £100 profit+ Initial investment £100. So, your trade value now is £200.
In case of the leverage trading, if the market moves in the same positive direction and the total trade value becomes £200 but the profit you obtain in this leverage trade would be 1000%. Astonished by the percentage of the profit!
Yes, this is true, because in the leveraged trade you paid £10 as your margin and borrowed £90 from the service provider. Now the trade value is £200, when you close the trade you pay back the borrowed money to the service provider that is £90. Your margin was £10 and the remaining amount £100 is your profit (which is a 1000% return for an initial payment of £10).
The following table gives the Total transaction value for different leverage ratios with the same amount of margin. Take time to understand the calculations given in the table.
Table 1: Leverage trades with different Leverage ratios, Margin percentage with Profit and Loss calculations
| Type of trade | Leveraged Ratio | Margin | Total transaction value in the trade | Margin Percentage | Profit/Loss in the trades | Insights |
|---|---|---|---|---|---|---|
| Normal trade | 1:1 | £300 | £300 | 100% | £30 | Normal trade with high initial payment and less profit |
| Leverage trades | 1:1 | £3000 | £3000 | 100% | £300 | 1:1 leverage trade is like normal trading |
| 10:1 | £300 | £3000 | 10% | No profit, you get back your margin amount back if you win the trade. | In case you lose, you should end the trade to stop further losses | |
| 20:1 | £300 | £6000 | 20% | £300 | This trade is where you start getting more profits | |
| 40:1 | £300 | £12000 | 40% | £900 | Risky leverage trades start from this ratio. You need to pay extra money if you even lose small | |
| 50:1 | £300 | £15000 | 50% | £1200 | Risky trades, attempt only if you’re an expert trader | |
| 100:1 | £300 | £30000 | 100% | £2700 | High profits and losses both are possible | |
| 200:1 | £300 | £60000 | 200% | £5700 | Very very risky | |
| 400:1 | £300 | £120000 | 400% | £11700 | Do not attempt such trades |
You can notice from the above table that the increased Total Transaction Value can provide you with either increased profit or increased loss.
With a margin of 10%, you will get back the margin amount you invested in your leverage trade. You will get profit only if your trade value increases. If you incur a loss of 10%, only your margin amount is lost in your trade, so your service provider will ask for more margin to continue your trade. This notification for more margin is called margin calls or variation calls.
4.Margin Call or Variation Call
When you start getting losses in your leverage trades, the service provider intimates you about this. When your losses increase more than the margin amount you invested, the Broker platform asks for more investment to be made into that trade. This intimation from the broker side is called the margin call or the variation call.
If there is money remaining in your trading account then the trade will continue. In case, there is no money remaining in the Account and you don’t respond to the margin call, the service provider closes your trade to stop more losses as a service provider will lose the money he lent to you for this leverage trade.
The same concept applies to other leverage trades with high leverage ratios. In the leverage trade with 100:1 leverage ratio, if it is a profit you will get 900% profit for your leverage trade. If you move on the opposite side and incur losses it may be huge.
But your losses can be stopped by a margin call. Say, your margin amount for a specific leverage trade is £300. When your losses in this trade nears £300 (till £300 the service provider takes the amount from the margin to execute the trade order) you will receive your margin call. If you close the trade immediately after margin call, you will lose only the margin amount you paid.
But if you invest more in the same trade as margin, your losses are going to be more if the market moves against you. If the market is favourable you can see profits, but it is a more risky decision to make.
So, the margin or variation call from the service provider side acts as an alarm for you. Proper decision making should be made at this time.
You can even use stop-loss order and limit order to decrease the loss percentage in leverage trading.
Negative Balance Protection
In some cases when you get a margin call you may not be a situation to close your leverage trade. The service providers may not close the trade from their side and start taking the money from your trading account for this margin trade that is continuously facing losses.
At a specific point when all the money from your trading account is used for this losing trade, your account balance may go negative. So, you may need to repay the amount that goes into a negative account balance to the service provider.
This is a hectic and tedious situation for many traders. The traders may need to pay back more than they can afford and may go into debt.
To stop this kind of money from being taken from the trading accounts without your knowledge, the regulatory bodies who regulate trading brought up a scheme called Negative Balance Protection.
Under this scheme, the service providers cannot take money more than the amount present in your trading account. Once the balance of your account comes to 0, the service provider should definitely close that specific leverage trade.
Negative balance protection is a rule in most of the regulatory bodies across various countries. All the regulated Broker-Dealer platforms follow this rule and you may not have any negative balances in your trading account.
The regulatory bodies followed this Negative Balance Protection scheme after many Broker-Dealer platforms used leverage trading to get more money from traders in an illegitimate manner. This affected the novice traders and beginners in trading who doesn’t know the working of leverage trading and lost more money in trading more than they could afford.
Now, after Negative Balance Protection, you need not worry to have a negative balance in your trading account. So, select a properly regulated broker which provides Negative Balance protection to margin trades.
Can leverage trading lead to more loss?
All the service providers give us a disclaimer that leverage trading may lead to a complete loss of your investment. According to them, it may also lead to more loss than your investment.
Investopedia also exclaims leverage trading to be a double-edged sword. But, according to thebalance.com, “These warnings, however, can be slightly misleading. Leverage trading can be more profitable if practised and consistently and executed skillfully. Most experienced traders use leverage trading to gain more profits.
These warnings are for novice traders and beginners to trading who may lose more if they used leverage trading without knowing what it is.
Now knowing completely about margin trading you can practise it with a small leverage ratio. Only trade with money which you afford to lose. Calculate both profit and loss for your leverage trades. Follow-up the market movements consistently. Use limit order, stop-loss order, etc to reduce your risks.
Advantages and disadvantages of leverage trading
Any kind of trading has both advantages and disadvantages. The pros and cons of leverage trading are listed below.
Table 2: Advantages and Disadvantages of leverage trading
| Advantages of Leverage Trading | Disadvantages of Leverage trading |
|---|---|
| You can earn more profits. | Chances of making more losses. |
| The initial investment required is less. | Risky. |
| Getting expertise can lead to more profits. | Needs more skills and expertise to reduce losses. |
| Very much profitable trading type for professional traders. | More service charge or commission. |
Steps to place and execute leverage order types
Select the leverage trading considering the margin and leverage ratio.
Following this process properly can lead to a successful leverage trade giving you good profits.
