Leveraging your trade is a great strategy to ensure your position is up for high returns. However, leverage is a double-edged sword; it can destroy your capital quickly.
Unfortunately, many traders are unaware of the deadly trait of leverage. Discover here how leverage works and the risks associated with it.
Lesson Highlights
- Leverage is the borrowed money brokers provide traders to control and maintain a position with high notional value.
- Using leverages can amplify both returns and losses. It lets you control and profit from big positions but also subjects your relatively small capital to significant risk with just a small market movement.
- To avoid facing significant risks due to leverage trading, a trader should have a clear goal and never let emotions take over their trade.
- The terms of use for margin trading vary from broker to broker. Under these terms, a trader can access important margin information, such as margin call and stop-out levels.
What Is a Leveraged Trade?
Leverage is your way to magnify your capital and access position with huge notional value. It’s your friend if you're after high and profitable returns.
Say you want to open a notional position valued at USD 200,000. However, you only have USD 50,000 in your account. In normal circumstances, you won't be able to open your desired position.
But when you leverage your trade for 50:1, you'll only need to put up USD 4,000 to enter the position.
Pro tip: Remember that having the buying power from leverage doesn't mean you should access all the possible positions. That's just dangerous.
Disadvantages of Leverage Trading
Overlooking the risks of leverage trading will cause capital ruin to your trading account. So, before you magnify your trade, it's essential to be aware of these deadly traits of leverage.
Magnified Losses
We all know that leverage magnifies your position's potential profit. But behind that are the magnified losses if the market goes against your position.
Magnifying your position also means heightening the market impact. A small market swing can significantly affect your initial investment.
To avoid this, you must have sound and proven risk management strategies. One of the best ways is to maximize automated orders, like stop-loss orders.
When you set up a stop-loss order for your account, your broker will prevent your position from suffering even more when the market reverses against you.
Emotional Trading
Greed, excitement, and fear are your enemies when trading; these emotional biases can only worsen when you trade with leverage.
Leverage trading is often correlated to emotional trading. When a trader uses leverage, the potential gains and risks induce emotional pressure. Emotional trading subjects you to poor judgment and faulty decision-making, which hinders you from becoming successful.
One of the best ways to battle your emotions is to develop a solid trading plan and, of course, stick with it.
Pro Tips: How to Trade with Leverage
Okay, you're already aware of the downside of leveraging your trade. Now, let's move on with the best practices that will keep you away from being a victim of leverage.
Strategize Your Trade
Having tested strategies is the best advice you'll get when you trade with leverage. With a proper strategy, your position won't be shocked once it enters the market.
The forex market is volatile; it fluctuates from time to time. Your position will surely suffer from it, but with a strategy, you can keep up with the volatility and profit from it.
But remember, a good trader acknowledges that the market is dynamic and ever-changing. They don't treat their strategies as one-size-fits-all.
You should acknowledge the fact that one strategy that works with one trade may not work with other trades.
Set Up Realistic Goals and Risk Tolerance Levels
When you're trading with leverage, your greed and excitement will most likely kick in. You'll think you can enter and profit from any position.
But that's just wrong. Having leverage can be deadly if you don't assess your financial situation and needs.
You should know your limit and only enter big positions if your capital can support them. Otherwise, your leveraged position won't have a safety cushion if the market goes against you.
Remember, professional traders only trade a position if they can afford half of its notional value; this principle applies even when trading on margin.
Read the Terms and Conditions
Your broker's terms and conditions should be the first thing you visit when you want to open a margin account. Through this document, you'll get to know the terms of use of their margin offering.
That is important because you must be familiar with your broker's margin call and stop-out levels. Remember, margin calls and stop-outs are events you won't want to experience. You should know these limit levels and try not to reach them.
In the next lesson, you'll explore the terror of margin calls and the best practices to avoid them.
