Guide to Leverage
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- What is Leverage in Trading?
- What is Margin Trading?
- Pros and Cons of Leverage
- Example of Leverage Trading
- Margin Call – How it Works
- Leverage Trading with AvaTrade
What is Leverage in Trading?
Leveraged trading is a powerful tool for CFD traders. It can help investors to maximise returns on even small price changes, to grow their capital exponentially, and increase their exposure to their desired markets. But it is worth noting that leverage can work for or against you. While you stand to earn magnified profits when asset prices go your way, you also suffer amplified losses when prices move against you. When you are trading with leverage, you put a ‘small amount’ down, but you get the chance to control a much larger trade position in the market. The small amount is what is referred to as ‘margin’. The amount of leverage a broker offers depends on the regulatory conditions that it complies with, in any/all of the jurisdictions it is allowed to offer trading services in.
With leveraged trading, the trader need only invest a certain percentage of the whole position. This can change depending on how much leverage the broker offers, how much leverage the trader would like to implement, and it also relies heavily on the regulatory authorities which are tasked with overseeing the online trading industry in that jurisdiction.
Also, traders use leverage depending on their level of experience, investing goals, their appetite for risk, as well as the underlying market they are trading. In most cases, it is professional traders that tend to use leverage more aggressively, whereas new and less experienced traders are generally advised to use leverage with caution. Also, conservative traders will tend to use the minimum level of leverage possible, whereas traders with a high appetite for risk can use leverage flexibly.
The type of market traded can also dictate the amount of leverage traders can use. Volatile markets, such as Gold and Bitcoin, should be traded with minimal leverage, whereas less volatile assets that do not post wide price fluctuations, such as the EURCHF pair, can be traded with higher leverage levels.
The leverage ratio is a representation of the position value in relation to the investment amount required. At AvaTrade, forex traders can trade with a leverage of up to . This however, varies depending on your jurisdiction as well as the asset class you are trading.
Consider this: with leverage of 400:1; you can control a $100,000 trade position in the market with just $250! This would mean that a 1% positive price change in the market will result in a profit of $1,000 (1% of $100,000). Without leverage, a 1% positive price movement will result in a profit of only $2.5 (1% of $250). This means that your trade positions and the resulting profits/losses are multiplied 400 times. This is why it is often stated that leverage is a double-edged sword. With trading leverage, profits are magnified, but losses can equally be devastating.
When trading with high leverage, it is very easy to lose more than your capital. But at AvaTrade, we offer guaranteed negative balance protection which means that you can never lose more than you have in your trading account balance. Plus you can practice for free on a paper trading account before investing real money and use use our trading calculator in order to estimate the possible outcomes of a trade before entering it.
What is Margin Trading?
As explained above, ‘margin’ is the amount of money a broker allows a trader to put down to trade a much bigger position in the market. It is essentially a security deposit held by the broker. When holding trading positions, price changes in the market will lead to changing margin conditions as well. On most platforms, information on the varying margin conditions will be displayed in your trading account. Here are what the various margin definitions and other terminologies mean:
- Account Balance
This is the total amount available in your account as your trading capital. It is essentially your trading bankroll.
- Margin Requirement
This is what we have discussed above as the amount your broker requires you to put down as a ‘security deposit’ to control a trade position in the market. It is often expressed as a percentage. For instance, if you use a leverage level of 100:1, your margin requirement is 1%. If you use leverage of 400:1, your margin requirement is 0.25%.
- Used Margin
This is the amount of money held as ‘security’ by your broker so that you can keep your open trade positions running. The money is still theoretically yours, but you can only access it after the open positions are closed.
- Usable Margin
This is the money in your trading account available for opening new trade positions in the market.
- Margin Call
A margin call is a notification by your broker that your margin level has fallen below the required level. This is a dreaded call (notification) for traders. A margin call occurs when losses of an open trade position exceed (or are about to exceed) your used margin. When you receive a margin call, you are essentially being asked to add more funds to your trading account to sustain open trades, failing which the broker will proceed to automatically close the open position. For instance, a margin call level of 20% means that your broker will send the margin call notification when your open trades have sustained losses of over 80% of your account balance.
Pros and Cons of Leveraged Trading
Pros of Leverage
- Boosts Capital. Leverage boosts the capital available to invest in various markets. For instance, with a 100:1 leverage, you effectively have control of $100,000 in trading capital with only $1,000. This means that you can allocate meaningful amounts to various trade positions in your portfolio.
- Interest-Free Loan. Leverage is essentially a loan provided by your broker to allow you to take a bigger position in the market. However, this ‘loan’ does not come with any obligations in the form of interest or commission and you can utilise it in any manner that you wish when trading.
- Magnified Profits. Leveraged trading allows traders to earn magnified profits from trades that go in their favour. Profits are earned out of the trade position controlled and not the margin put down. This also means that traders can earn substantial profits even if underlying assets make marginal price movements.
- Mitigating Against Low Volatility. Price changes in the markets usually occur in cycles of high and low volatility. Most traders like trading highly volatile markets because money is made out of price movements. This means that periods of low volatility can be particularly frustrating for traders because of the little price action that occurs. Thankfully, with leveraged trading, traders can potentially bank bigger profits even during these seemingly ‘dull’ moments of low volatility.
- Trading Premium Markets. Leverage makes it possible for traders to trade instruments that are considered to be more expensive or prestigious. Some instruments are priced at a premium and this can lock out many retail investors. But with leverage, such markets or assets can be traded and expose the average retail investor to the many trading opportunities they present.
Cons of Leverage
- Amplified Losses. The biggest risk when trading with leverage is that, like profit, losses are also amplified when the market goes against you. Leverage may require minimal capital outlay, but because trading results are based on the total position size you are controlling, losses can be substantial.
- Margin Call Risk. The dreaded ‘Margin Call’ from your broker occurs when floating losses surpass your used margin. Because leverage amplifies losses, there will always be an ever-present ‘margin call’ risk when you have open trading positions in the fast and dynamic financial markets.
Example of Leverage Trading – Retail Clients
Let’s look at another example, this time with Gold. The price of 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.
Margin Call – How it Works
In order to employ leverage, a trader must have sufficient funds in his account to cover possible losses. Each broker has different requirements. 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 invests $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), in 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
In this example, we’ll take the price of one Troy ounce of Gold at $1,327. The trader believes the price is going to rise and wishes to open a large buying position for 10 units. The full price for this position would be $13,270, which is not only a large amount to risk, but many traders may not possess such amounts. Using the 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 just $66.35.
Margin Call – Pro/Non EU clients
In order to employ leverage, a trader 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 invests $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 positions.
On AvaOptions all the client’s positions will be closed simultaneously, 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 available which can also change based on the trading platform you choose to work with. It is important to make sure you know the available leverage before you start trading.
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.
Finally, it’s worth trying out our AvaProtect feature. It is a risk management tool that protects your open positionsif you set it up before you open the trade.
It lasts as long as you want it to, and if your trade is losing upon expiry, you will get all the money back into your account, minus the fee you paid for the AvaProtect™ facility.
Leverage main FAQs
- Can leverage cause my account go negative?
Because AvaTrade uses a 50% margin requirement and the use of the margin call your risk of excessive trading losses that exceed the total balance of your account is minimized, but it is not eliminated completely. During a period of extreme volatility, it is possible that a position could move so rapidly against you that it is not possible to liquidate a losing position in time to keep your account balance from going negative. To avoid this, we strongly recommend that you manage your use of leverage wisely.
- What is the difference between leverage and margin?
While leverage and margin are closely interconnected, they are not the same thing. Both describe borrowing in order to trade in the financial markets, however leverage refers to the act of taking on debt, while margin is the actual money or debt that the trader has taken on to invest in financial markets. The leverage ratio is a representation of the position value in relation to the investment amount required, (for instance, 100:1) while margin is the actual amount held by the broker to create the leverage, which is expressed as a percentage of the total position. For example, with 100:1 leverage you can control $100 of an asset with only $1 (equal to 1%) in margin.
- Are there any disadvantages of leverage?
Leverage is a very complex financial tool and should be respected as such. While it sounds fantastic in theory, the reality can be quite different once traders come to realize that leverage doesn’t only magnify gains, but it also magnifies losses. Any trade using leverage that moves against the trader is going to create a loss that is much larger than it would have been without the use of leverage. This is why caution is recommended until more experience with leverage is gained. This can lead to a longer and more prosperous trading career.
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We recommend you to visit our trading for beginners section for more articles on how to trade Forex and CFDs.
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