Leverage is the use of borrowed funds to increase one’s trading position beyond what would be available from their cash balance alone. Brokerage accounts allow the use of leverage through margin trading, where the broker provides the borrowed funds.
- What is Leverage in Trading?
- Pros and Cons of Leverage
- Example of Leverage Trading
- Margin Call – How it Works
- Leverage Trading with AvaTrade
What is Leverage in Trading?
Leveraged trading, also known as margin trading, is a facility offered by many brokers, that allows the trader to amplify the value of his or her trades. That means opening positions much larger than his or her own capital would allow. This can increase the traders’ rewards, but it can also increase their risk too.
To use leverage in trading, the trader need only invest a certain percentage of the whole position. This can change depending on how much leverage the broker offers, how much leverage the trader would like to implement and it also relies heavily on the regulatory authorities tasked with overseeing the online trading industry in that jurisdiction.
Leverage is commonly used nowadays, especially by more experienced traders, whereas newbies should exercise caution when it comes to using leverage.
“Leverage” usually refers to the ratio between the position value and the investment needed. For instance at AvaTrade, traders can opt to use forex leverage of up to 400:1 (although this varies, depending on where you are trading from).
Let’s assume you are placing a trade for $50, if you use leverage of 400:1, this multiplies your trade 400 times. That means 50 x 400 =2000. Your trade is now worth $2000, rather than $50 and any profit you bring in would be reflected by that amount.
Unless a broker offers Negative Balance Protection, meaning stopping you out before your account goes into minus, then if you aren’t successful in that trade your loss can be multiplied 400 times.
It’s also important to understand “Margin” here too. Note, that in your account balance details, the margin is the most important number represented there. It is the amount of money you are putting forward and is almost like a security deposit held by the broker.
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Pros and Cons of Leveraged Trading
Pros of Leverage
- Minimizes the capital the trader has to invest. Instead of paying the full price for an instrument, the trader need only pay a small portion of it.
- Some instruments are relatively cheap, meaning the majority of traders can trade them easily. However, some are considered more premium, and their price reflects that. This can rule some traders out based on their available capital and their trading strategy. Instead of investing large amounts in order to participate in that market, one can use leverage and enjoy the fluctuations in the price of those more prestigious instruments.
Cons of Leverage
- While leveraged trading, or margin trading may require less capital outlay, which can be a major advantage for many traders, as mentioned earlier it also comes with a loss risk. It is important to keep track of opened positions, and apply stop loss and other risk management tools, in order to prevent large-scale losses or to avoid a “Margin Call”. This is where the broker requests that the trader deposit additional money to bring it to the minimum amount.
Example of Leverage Trading – Retail Clients
Let’s look at another example, this time with Gold. The price of one Troy ounce of Gold is $1,327. The trader believes the price is going rise and wishes to open a large buying position for 10 units.
The full price for this position will be $13,270, which is not only a large amount to risk, but many traders do not possess such amounts.
With a 20:1 leverage offered by AvaTrade, or a 5.00% margin, the amount will decrease substantially. Meaning that for every $20 of worth in the position, the trader will need to invest $1 out of his account, which comes to $663.5 only.
Margin Call – How it Works
In order to employ leverage, a trader must have sufficient funds in his account to cover possible losses. Each broker has different requirements, and AvaTrade requires a Retail Trader to possess Equity of at least 50% of his Used Margin for MetaTrader 4 and AvaOptions accounts.
Going back to the example above, the position’s original value is $13,270; for both MetaTrader 4 and FX options accounts. With leverage, the trader invests $663.5 of his capital, and if he has 50% of this used margin in equity, i.e. $331.75, his positions will be kept opened.
If, however, the trader has losses and his Equity drops below 50% of used margin on MetaTrader 4 and AvaOptions accounts, the broker will shut down the client’s position(s), in a “Margin Call”.
On AvaOptions all the client’s positions will be closed, while MetaTrader 4 will shut down the largest losing position first, and will continue to close positions until the equity level returns above 50% of the used margin.
Example of Leverage Trading – Pro/Non EU clients
In this example, we’ll take the price of one Troy ounce of Gold at $1,327. The trader believes the price is going to rise and wishes to open a large buying position for 10 units. The full price for this position would be $13,270, which is not only a large amount to risk, but many traders may not possess such amounts. Using the 200:1 leverage offered by AvaTrade, or a 0.50% margin, the amount will decrease substantially. Meaning that for every $200 of worth in the position, the trader will need to invest $1 out of his account, which comes to just $66.35.
Margin Call – Pro/Non EU clients
In order to employ leverage, a trader needs to have sufficient funds in his account to cover possible losses. Each broker has different requirements, and AvaTrade requires a Pro/Non – EU Trader to possess Equity of at least 10% of his Used Margin for MetaTrader 4 and AvaOptions accounts.
Going back to the example above, the position’s original value is $13,270 for both MetaTrader 4 and FX options trading accounts.
With leverage the trader invests $66.35 of his capital, and if he has 10% of this used margin in equity, i.e. $6.64, his positions will be kept opened.
If, however, the trader has losses and his Equity drops below 10% of used margin on MetaTrader 4 and AvaOptions accounts, the broker will shut down the client’s positions.
On AvaOptions all the client’s positions will be closed simultaneously, while MetaTrader 4 will shut down the largest losing position first, and will continue to close positions until the equity level returns above 10% of the used margin.
Leverage Trading with AvaTrade
AvaTrade offers many instruments, and each has a different leverage available which can also change based on the trading platform you choose to work with. It is important to make sure you know the available leverage before you start trading.
In order to avoid a margin call always make sure you have enough equity in your account’s balance so you can continue your trades undisturbed.
Finally, it’s worth trying out our AvaProtect feature. It is a risk management tool that protects your open positions, if you set it up before you open the trade.
It lasts as long as you want it to and if your trade is losing upon expiry, you will get all the money back into your account, minus the fee you paid for the AvaProtect facility.
Leverage main FAQs
Can leverage cause my account go negative?
Because AvaTrade uses a 50% margin requirement and the use of the margin call your risk of excessive trading losses that exceed the total balance of your account is minimized, but it is not eliminated completely. During a period of extreme volatility, it is possible that a position could move so rapidly against you that it is not possible to liquidate a losing position in time to keep your account balance from going negative. To avoid this, we strongly recommend that you manage your use of leverage wisely.
What is the difference between leverage and margin?
While leverage and margin are closely interconnected, they are not the same thing. Both do involve borrowing in order to trade in the financial markets, however leverage refers to the act of taking on debt, while margin is the actual money or debt that the trader has taken on to invest in financial markets. So, leverage is referred to as a ration, such as 1:30 or 1:100, which indicates how much debt can be taken on to open a position, while margin is referred to as the actual amount borrowed to create the leverage. For example, with 1:100 leverage you can control $100 of an asset with only $1 in margin.
Are there any disadvantages of leverage?
Leverage is a very complex financial tool and should be respected as such. While it sounds fantastic in theory, the reality can be quite different once traders come to realize that leverage doesn’t only magnify gains, but it also magnifies losses. Any trade using leverage that moves against the trader is going to create a loss that is much larger than it would have been without the use of leverage. This is why caution is recommended until more experience with leverage is gained. This can lead to a longer and more prosperous trading career.
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Check out more articles in our Forex and CFDs educational guides. Good luck.