By: Wayne Duggan
Traders with a cash account must have enough money in their account to pay for each share of stock they buy. If you have $1,000 in your account and identify the trading opportunity of a lifetime, you’ll still only be able to invest $1,000 unless you use leverage.
Professional traders typically borrow money to trade, and this leverage allows them to invest more cash than they have in their accounts. Leverage trading creates opportunities for significantly higher returns, but it also comes with its own unique set of risks.
What Is Leverage Trading?
Leverage is defined as the amount of money with which you are able to trade divided by the amount of money in your trading account. Traders typically use leverage to take large positions with a relatively small amount of cash. Typical retail traders have access to leverage ranging from around 5:1 to as much as 100:1 depending on the circumstances.
Leverage is expressed as a ratio, whereas margin is expressed as a percentage. Margin is used to create leverage, and margin is calculated as the amount of money in your account divided by your leverage.
For example, an account with a leverage ratio of 50:1 (or 50 times) has a margin requirement of 2% (1 divided by 50). A trader who has $1,000 in that account could take positions of up to $50,000.
A number of factors determine how much leverage a trader can access. Maximum leverage depends on the type of assets being traded, the trader’s broker, the trader’s experience and the financial laws of the trader’s home country.
Pros of Leverage Trading
There are several advantages of using leverage in your trading strategies. The most obvious pro is that leverage trading can amplify your profits.
Another key advantage is that leverage allows you to get more for your money. If you only have $1,000 in your account, you may not want to put just $200 into 5 different stocks. But if you use 5:1 leverage, you could put $1,000 into 5 different stocks.
For certain foreign exchange trades and commodity trades, minimum position sizes can be extremely large. Without leverage, it would be difficult for most retail traders to afford even the minimum amount of cash needed to trade.
Finally traders can use margin to make additional trades without having to wait for previous trades to settle, which typically occurs 2 days later.
The Cons of Leverage
At least 1 obvious risk to leverage trading exists, which is that potential losses are also amplified. A 10% loss is manageable, but that 10% loss turns into a 50% loss when trading with 5:1 leverage.
In addition, if you use your maximum leverage and a trade doesn’t go your way right out of the gate, your broker may call on you to deposit additional cash. In extreme cases, your broker may close out an open margin position at market price without your consent. This phenomenon is known as a margin call and can result in a stock potentially being sold at the worst possible time.
Finally, like any other loan, traders must pay interest on all margin used, which can eat into profits.
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