What is Leverage and How to Use it in Trading?
Leverage is the use of borrowed funds from your brokerage to have a bigger position than you would be capable of having with just your cash balance in your account.
The leverage offered by a broker will vary and can range from one to ten (1:10), one to twenty (1:20), one to fifty (1:50), one to a hundred (1:100, or even one to a thousand (1:1000). Each of these means that you have your account times the leverage you get in buying power. For example, let’s say you have a 1:10 leverage, one is equal to the cash amount in your account, and your account balance is 1. Let’s say you have a $100 account. You would have 1000 of margin or buying power.
According to the blog titled “What is Leverage in Trading?” on the PrimeXBT, leverage trading lets traders put up only a small fraction of the total position required for collateral, and the broker will supply the rest with debt capital. The article covers almost everything about leverage, including the advantages of leverage trading and the risks of leverage.
Why Do Most Beginners Blow Their Accounts When Using Leverage?
With a $1000 account with no leverage, the number of units you can purchase at a time is 1000 units, which is a micro lot worth 10 cents per pip. That means if you have a $1000 account, you can trade at a maximum of 1000 units of currency.
For example, 1000 units of the EUR/USD mean that every pip, the EUR/USD moves at 10 cents per pip. Look at the risk as to how many pips you can lose; in this case, you have to lose 10000 pips to blow your account. If you are not using leverage at the beginning, that’s a pretty good idea because 10000 pips, for example, is a lot of breathing room. To lose 10,000 pips means you have to lose many trades to blow your account.
Here is where leverage can hurt you. Let’s use the 1000 dollars account as an example, but with a 1:50 leverage, that is $50,000 buying power. Keep in mind that the broker won’t allow you to lose all $50,000; before you lose the $1000 dollar you have, they will do the margin call. Your capital ($1000) is called margin. Fifty to one on leverage means that you have, for every one dollar of margin, $50 that you can put into a position. So, in this case, let’s say you max it out and say I have 50,000 units to trade, so you buy the EURUSD. The value per pip on this trade becomes $5.
You can make money with $5 per pip than at 10 cents per pip. But as a beginner, you are going to swing and miss most of the time, but if you have your entire account, your $1000 in the margin, which gives you $50,000 in buying power on this position, how many pips do you have that you can lose before your account goes to absolute zero? Where it was 10000 pips now is 200 pips. With high volatility in the market, you can lose your entire account in 1 day.
That’s the reason why most beginners using leverage end up blowing their accounts before they have a chance to make any money at all. That’s the danger of leverage. You don’t want to max out and be trading with leverage and trading your entire account value because that gives you a very small margin of error.
How to Properly Use the Leverage
To remain safe, do the following when using leverage:
- Always use a stop loss
If you are not using a stop loss when using a leveraged account, then you are putting yourself in a risky situation, and for traders avoiding risk is half the battle.
- Have a good risk management plan
Leverage has the capacity to increase your earnings or losses by an equivalent amount. The risk you take increases with the leverage you apply to your capital. It should be noted that this risk is not always tied to margin-based leverage. However, if a trader is not diligent, it may have an impact.
Leverage is a double-edged sword
Leverage allows you to be in more trades at one time and to put an initial deposit down of a small account in order to purchase a larger one. Leverage should never be employed if you let your transactions run their course without your involvement. Otherwise, with correct management, leverage may be used effectively and productively.