Greetings traders and welcome back to another In Depth with Chris episode.
In today's discussion, we'll be talking about leverage,
and I'm not talking about the type of action where
we use a stick over a fulcrum in order to elicit a higher
power than we might be capable of doing.
No, instead we're talking about financial leverage.
It's the art of using more money then you might have access to
yourself or choose to use yourself. When understood correctly,
it can provide some very awesome
benefits, but when understood incorrectly or really not at all,
it can be very dangerous.
It's important to cover this subject and we're going
to cover exactly what it is, how it works, and some of the
pros and cons that go into it,
so at the end of all of this you should know whether or not
leverage seems right for you. Without further ado, let's jump into that material,
and while we're going through these disclaimers,
please click that like and subscribe button down below
because it allows me to keep coming out with content
for you guys out there. Let's dive into it.
Trading on financial leverage can significantly increase
your profit margins without having to put down a massive
initial capital deposit, but we do need to know what we're doing.
As Warren Buffett famously said, "when you combine ignorance
and leverage, you get some pretty interesting results."
What is leverage trading? Well, leverage in physics provides
a mechanical advantage by amplifying a small input force
to achieve a greater output force. Financial leverage, as it
pertains to trading, follows the same principle. In this case
however, it amplifies the investor's buying power in the market.
Also known as margin trading, leverage trading refers to the
use of borrowed capital to get a much higher potential return
on our investment.
This allows us to open positions that are significantly larger than what
our original capital would have otherwise allowed.
The idea here is to use that additional capital to buy more units
of an asset with the expectation that the profit from the
position will be greater than the cost of borrowing.
But just as leverage can increase those potential rewards, it also
raises risk exposure, which is why it is mainly used by experienced traders.
Leverage can also refer to the amount of debt a company
uses to expand its asset base and finance capital intensive purchases.
For example, instead of issuing new stocks to raise
capital, the company can use debt to acquire more assets and
improve their business operations.
To be properly in the know, we should be aware of the different
lingo words that traders use when they are trading on a leveraged account.
Now, some of these words are just used in regular trading as well,
but they also cross apply to leverage trading.
The first is "buying power" and this references the amount that
we have available, plus leverage, to buy securities with.
Then we have "coverage". The coverage is the ratio of the net balance
in our trading account in relation to the leveraged amount.
Next we have "margin".
Margin is the amount required by our broker to cover possible
losses, should the trade become unfavorable. Margin is
one of the pillars of leverage trading and we should be familiar with this word.
Then we have everyone's favorite word, that's total sarcasm,
and that's the "margin call". The broker or financial intermediary
will issue a margin call if our trading account balance
falls below a specified minimum requirement.
It's basically a warning that our position is
exposed to a risk level that the broker does not want to
accept. You'll then need to add more funds to our trading account
to meet that minimum requirement amount.
Alternatively, we could just close off the trading position entirely and
face are our accrued losses.
Then we have the "open position".
This means that we've established a trade and have not yet
closed it out with an opposing trade.
Let's say we own 1,000 shares of Amazon stock.
This means that we have an open position in Amazon stocks
until we close it out. Then we have the "close position".
This just means the state of our investment at the time that we closed it.
So if we open a position at say $20, and it rose to $25,
and we close the position at $25 to realize our profit of
$5 on the trade, then our close position was are $25 close.
Then we have a "stop-loss," and the stop-loss is something that
is going to help us limit risk exposure on a trade by automatically
closing a position based on certain parameters.
If the trade goes below a specified price level, it triggers
the stop-loss automatically and closes the position in order to limit further losses.
We can trade with leverage through a broker.
We can think of it as getting a loan to purchase an asset.
We have our initial capital, then we have the broker financing
the remaining portion of the position. Any difference between
how much we purchase the asset, the opening price, and how
much we sold it for, the closing, price is settled in our account balance.
If we have significant leverage and the asset appreciated greatly in value,
then the amount owed to the broker is taken out of our profits on that trade.
However, if the trade went south and we ended up with a loss on our hands,
then the amount is owed and is taken out of what is left
in our account. For this reason, leverage trading facilities are
not readily available to every trader. The amount that a broker
will be willing to finance will depend on a number of factors.
This could include how much leverage the trader needs and
the current regulations covering online trading in that particular jurisdiction.
Financial leverage is always shown as a ratio
between the total assets and the equity.
Let's take a moment and ignore this guy down here, who
I was trying to bring into this to show you facial ratios.
That was the joke there, but he is quite scary.
Financial leverage is going to be equal to the total assets
divided by the equity, which is equal to the equity plus debt divided by equity.
Some brokers, specifically in the Forex markets, allow
traders to use leverage up to 100 to 1 or even more in some countries.
In this instance, this means that we can leverage
our trading position up to 100 times its actual value.
Let's say we have $2,000, and this is our equity
or capital that we have. If our broker allowed leverage of
100 to 1, we can expose ourself to a position of $200,000
in the market because 2,000 times 100 is 200,000.
Our broker will effectively allow us to borrow $198,000 for the position. Any profit
or loss will be magnified by 100 times.
Now we can see why it's important to make sure we're doing
this responsibly, and we're doing this with a plan in action.
Some brokers offer negative balance protection, also referred
to as NBP, and this essentially stops us out before our trading
account hits negative in the event of a loss to protect us
from losing more than we have access to ourselves.
Without this protection feature, we could end up owing a deal of money to the broker,
so the NBP is quite nice for traders who are trading with leverage.
If we continue on with our 100 to 1 leverage example
from the previous slide, let's say that we bought an asset
at a price of $10 per unit and the price went up to $10.50.
If we close out the position, what would be the results of our trade?
Without leverage, the asset gained fifty cents and
for $2,000 we bought 200 shares. Our total profit in this
case would be $100 because fifty cents times 200.
But with leverage, if we applied the leverage of that 100 to 1 like
we talked about, this means we bought 20,000 shares and our
total profit on the trade becomes $10,000 because it is
fifty cents times 20,000.
This is just a glimpse of how much profit we can make from
the same $200,000 with the help of leveraged trading.
Obviously, if it were to go the other way around
our losses would be the equivalent.
We can apply leverage trading to several financial instruments,
honestly just about everything.
This includes stocks, Forex, commodities, futures, options, ETF, indices, and
even cryptocurrencies. Financial leverage is also used when buying real estate.
Our mortgage is the debt in the financial leverage formula.
Our down payment is the equity in the formula.
Each asset class has its maximum leverage limitations in
line with whatever market regulations of the area, as well
as the broker's own efforts in promoting leverage trading
on their platform. The availability of leverage is quite wide.
But what is the difference between leverage and margin?
Although closely interconnected, leverage and margin are not
exactly the same thing. Financial leverage means were taking
on debt to boost our buying power. We do this because we believe
the asset or security that we're buying will bring in more
profit than the original cost of the debt.
On the other hand, margin is the amount of capital that we need to have available
in order to create and maintain the leverage.
Similar to a down payment before we can access a loan.
If our account balance falls below a predetermined level
during the trade, then we will incur the margin call of which
we talked about earlier. The security we want to trade, our
trading account balance, our trading expertise, and the leverage
policy of the broker are some of the things that will determine
how much leverage we can get with our margin account.
There are four key tips to making the most out of trading
with leverage, and because of the risks, leverage trading
is best left to experienced traders, but if you are interested
in getting started, the first tip we're going to provide
is to know your financial situation.
We want to work out how much of a loss we're willing and able
to incur on a trade based on our financial situation.
We want to start small and work our way up to taking on only
leverage ratios that we can firmly manage.
Then, we want to perform sound analysis before opening our position.
This sounds like common sense, but this is
an important aspect of trading on leverage, and
it's more so than regular trading because once again, everything
we're doing is multiplied.
Then, we want to always consider a stop-loss.
A stop-loss is a must. Outside of our trading experience, applying a stop-loss
order on our open positions is the first practical tip
to measure and minimize the risk associated with leverage trading.
Then on the the opposite side of that coin, on the happier side of the coin,
we have set up a take-profit order.
If a stop-loss is the defense, we can think of the take-profit
order as the attack. This tool automatically closes out our
position once it hits the profit target.
By implementing both of these, the stop-loss and take-profit,
it allows us to be more in control of what's going on in
the market, even if we're not physically able to respond to those particular
actions fast enough on the fly.
The advantages of trading with leverage are relatively easy to see.
The first is that we have amplified buying power to
purchase more units with only a fraction of the actual cost.
This means, we buy more with less and obviously that can be
a very big benefit if we are right in our analysis.
Then the second advantage is the potential for higher profit on
each trade, which obviously ties into number one.
We have higher profit potential because of the fact that
we have amplified buying power.
Then number three' we can reduce our non systematic risk,
since we only need a small percentage to control a large
position of a diversified asset.
The potential disadvantages can be summed up with two categories.
The first is amplified risk exposure. Even with the ability
to set up stop-losses, leverage trading carries significant
risk, and that's just the fact of it.
Then number two is losses sustained while trading with financial leverage
are usually way more than we would have had incurred if we
didn't trade with leverage at all. Once again, this is
neither positive nor negative.
It's just a fact that is. If we win, we win big. If we lose, we lose big.
In conclusion, leverage trading is easily one of the most
powerful tools available to investors that are looking to
amplify their gains, but it is always important to remember
that nothing in trading is guaranteed, and if a trade doesn't
go our way while we're using leverage, it will amplify our losses as well.
It's neither good nor bad.
It's neither positive nor negative. It is what we choose it to be.
It is going to be a product of our results.
If we are winning traders, it will make us more of a winning trader.
If we are losing traders, it will make us more of a losing trader.
The key here is to pay attention to our trading strategy
and everything else, and make sure that we're actually succeeding
before we think about incurring leverage on our accounts.
But until next time folks, thank you for joining me
as always. Please click that like and subscribe button down
below. I appreciate it quite a lot. I will see you all very soon.