Margin trading is a popular form of leverage that allows traders to invest amounts than they would be able to with their capital. The idea of leverage in your investment portfolios is appealing because it helps you to make more money with less capital. Before taking on any additional risk, you should consider the several drawbacks. In this blog post we will explore the pros and cons of using leverage in the financial markets.
Understanding Leverage
Leverage is the ratio between the amount of money in your trading account and the amount you can trade with. Leverage is used in financial markets to borrow funds to invest in assets, such as stocks, currencies, or commodities. Leverage allows traders to gain greater exposure to financial market positions with relatively small capital. For example, five times leverage means that, for every dollar invested, you have access to $5 worth of trading capital. In crypto trading, leverage can be anything from 5x to 100 times or more.
How Does Leverage Work?
Trading Without Leverage
You have a $1,000 trading account, and you want to buy shares of ABC Corporation. The current share price is $1.00 per share. You buy 1,000 shares, so your investment is $1,000. If the share price goes up by 5%, you can sell out of your position for $1.05 per share:
Return: 1,000 shares x $1.05 = $1,050
Profit $50 (or 5%)
Trading With Leverage
When you use leverage, you can get exposure to many more shares than you could buy outright. For example, when you buy ABC Corporation shares using 20x leverage, you could get exposure to 20 times as many shares, i.e. 20,000 shares, but only commit 5% of the money (called margin deposit or initial margin):
Current share price: $1.00
Actual Cost (margin) $1,000
Exposure $20,000
If the share price goes up by 5%, you can sell out of your position for $1.05 per share:
Return: 20,000 shares x $1.05 = $21,000
Profit $1,000 (or 100% of your $1,000 investment)
Pros of Using Leverage
Increased Profit Potential
One of the main advantages of using leverage is the ability to generate higher profits. By borrowing funds to invest in assets, traders can magnify their gains. For example, if a trader invests $10,000 in stock and the stock rises by 10%, they would make a profit of $1,000. However, if the trader uses leverage to invest $100,000 in the same and the stock rises by 10%, they would profit $10,000.
Access to More Trading Opportunities
Another benefit of using leverage is the ability to access more trading opportunities. With limited capital, traders may be unable to invest in certain assets or markets. However, with leverage, traders can access a broader range of opportunities, potentially leading to higher profits.
Flexibility
Leverage also provides traders with more flexibility in their trading strategies. Traders can use leverage to take advantage of short-term market fluctuations or to hold positions for long periods. This flexibility can help traders adapt to changing market conditions and improve their overall trading performance.
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Cons of Using Leverage
Increased Risk
A disadvantage of using leverage is the increased risk. When traders borrow funds to invest in assets, they essentially use debt to finance their investments. That means that if the investments do not perform as expected, the trader may lose their initial investment also, owing money to the lender.
Margin Calls
Margin calls are another risk associated with using leverage. When traders use leverage, they are required to maintain a certain level of equity in their accounts. If the value of their investments falls below this level, the broker may issue a margin call, requiring the trader to deposit additional funds to cover the losses. If the trader cannot meet the margin call, the broker may liquidate their position, resulting in significant losses.
Psychological Pressure
Using leverage can also create psychological pressure for traders. The potential for higher profits can lead to greed and overconfidence, causing traders to take on more risks than they can handle. That can lead to impulsive trading decisions and ultimately result in significant losses.
Conclusion
Margin trading and leverage can cause more flexibility and greater market exposure, but traders should carefully consider their risk tolerance and trading strategy before committing leveraged money to the markets. Depending on the nature of your investment, there are many ways to use leverage to maximize profits. It is important to remember that leverage is not a guarantee of success, and you should always use it with caution.
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