What is leverage in trading?
Now, if you are starting to walk the path toward investment, this is not the only question you should ask yourself. In addition to proposing a time horizon to achieve your goals, you must know how much risk you are willing to take. That is where the concept of the profitability/risk binomial appears.
Leverage in trading is making a trade or investment with borrowed funds as your primary capital outlay. So, financial leverage is the act of borrowing money to trade or invest in an asset or market in the hopes of profiting.
When we talk about return and risk in the investment world, we mean that when we seek more return, we will expose ourselves to more risk and vice versa. Today we are going to explain what leverage in trading consists of, a way to achieve excellent returns but with the counterpart of exposing ourselves to many risks.
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Table of Contents
Types of Leverage
- Combined Leverage
- Financial Leverage
- Working Capital Leverage
- Operating Leverage
How does leverage in trading work?
To begin, we are going to make a definition of financial leverage, which refers to the possibility of operating with borrowed capital in the financial markets. Financial leverage allows us to work on the stock market with more money than we initially have. And how can I make a trade with leverage? Well, brokers offer this possibility to investors.
Now, brokers work with different margins. Leverage margins are the minimum capital you have to contribute to qualify for a more significant amount of money. This amount of funds is used to cover possible losses, but this is much better explained with an example:
Suppose you want to buy ten shares of security like Tesla, which at the time of writing is $850–875. However, you do not have as much cash, but your broker allows you to buy them with a margin of 10:1.
You only need 10% of the total amount to buy all ten shares. With 850 dollars, you can acquire assets worth 8,500 dollars.
We could call this financial leverage in a much more straightforward way that we all surely understand: indebtedness. In the end, power works like a mortgage, in which you give an entry (in this case, we are talking about the margin we pay), and you receive a house (in trading, the financial asset to buy).
The advantages and disadvantages of leverage in trading
Leverage in trading, like any other financial instrument, has advantages and disadvantages that you should be aware of before using in your business or personal investments. Because leverage is a multifaceted financial tool, it is somewhat complex, and when used by a company or an individual investor, it can increase both gains and losses. Understanding its advantages and disadvantages will assist you in expanding your business and determining whether your company is ready to use this financial tool at this time.
- The most significant advantage of leverage is that it increases the company’s liquidity because when a company takes out a loan or debt, it receives cash from the lender, which can be used for various purposes.
These activities include purchasing new machinery or constructing a brand-new building, increasing the company’s efficiency. The firm can use the cash to acquire other companies, expand the company’s scale of operations, and so on.
- Another advantage of leverage is that, in the case of a growing company that requires cash for operations, the use of debt can result in the company’s profits being multiplied.
This is because the cost of debt ranges between 8 and 15%, whereas the rate of profits in the case of a growing company can range between 20% and 100%.
As a result, leverage tends to magnify gains as long as the company expands.
- When leverage investment is not used correctly, it can be fatal to businesses, even leading to failure.
In this case, less experienced investors are advised to avoid it until they have significant knowledge.
- A company’s reliance on leverage may expose it to serious risk, eventually leading to its demise if the problem is not resolved.
As a result, companies with average or below-average profits may be able to use leverage to cause more harm than good. This financial risk is especially prevalent in specific industries, such as construction, oil production, and automobile manufacturing, which may suffer the most significant losses if asset values fall.
How to minimize the risk involved in leveraged trading
When analyzing your leverage risk, try to implement a risk management process or risk management framework. This should include but is not limited to the below strategies:
Prevent losses. Use these to close trades automatically when losses reach a certain amount.
Take profit orders. You can use this method to automatically close positions when they reach a particular value.
Negative balance protection. Brokers provide this method in some cases to protect against market conditions that cause equity to fall to zero. Therefore, bearing means the loss on your behalf.
Borrowing money allows businesses and individuals to make investments that would otherwise be out of reach or better use their existing funds. Individuals may discover that leverage is the only way to afford significant purchases such as a home or a college education.
While leverage has a lot of upside potential, it can also cost you more than you borrowed, mainly if you can’t keep up with interest payments.
At least when it comes to investing, leverage should be reserved for seasoned professionals until you have experience and can afford to lose money.