Every trader needs to understand that trading with leverage results in higher profits and losses than trading without leverage.
It's important to accept that using leverage can involve risks and understand the potential downsides of this strategy before opening your positions. Usage of leverage may require special attention to orders and the deposit of additional capital if there are not enough funds in the account to support your trading.
Rational usage of leverage can build your strategy for making profits and minimizing losses. You can read more about this in the article regarding leverage and margin and learn more about Margin Call and Stop Out.
What are the advantages and risks of using leverage?
- It brings more opportunities for traders to access more expensive trading (reduces barriers to entry);
- Winning investments are amplified, potentially creating more significant profits;
- Using leverage can free up capital that can be committed to other investments;
- Using leveraged trading instruments to speculate on market movements to take advantage of markets that are falling, as well as those that are rising – this is known as going short.
While leveraged trading is a helpful tool to enable more flexibility and greater market exposure, it's vital to understand the risks before trading.
- In case you used your leverage to invest the majority of your funds in one position, if the market moves against you, there is a possibility of a rapid loss of funds;
- Leverage magnifies losses and profits. Since your initial funds are comparatively smaller than conventional trades, it's easy to forget the amount of capital you're placing at risk. You won't be able to lose more than the balance on your account, but you should always consider your trade in terms of its total value and downside potential – and take steps to manage your risk.
- Trading with higher leverage. In addition to a simple magnification of PnL, it might damage your odds of success on any particular trade. If the leverage you use is so high that the margin supporting your order is less than 10-20 of the value, the chance of losing quickly increases. It happens because the value eats the supporting margin, resulting in a high probability of closing.
For example, your supporting margin is equal to your transaction costs. You open an order, and transaction costs will leave you with zero supporting margin on your order. As a consequence, this will cause your order to be closed immediately, regardless of your trading strategy or market movement.