Why Leverage Is Extremely Important
Leverage is used to magnify returns and offers the possibility of high payoffs from small investments.
In trading, leverage is an extremely important concept. The use of leverage has become a standard practice for traders on all markets worldwide.
Here we’d like to share with you some critical knowledge about leverage. Understanding the mechanics of leverage is essential for successful trading.
How Leverage Is Applied In Trading
Leverage is a mechanism allowing you to buy cryptos by borrowing some of the purchase price. The borrowed money is provided by your broker and is called the margin loan. Hence the term to buy on margin.
Your equity is that portion of the purchase price that you must supply to enter a trade. It is called the required margin.
Buying cryptos on margin can greatly increase the potential gains for a given amount of equity in a position because you can buy more on margin than you could otherwise.
Therefore, while your initial equity is not changed, the magnitude of profit or loss is multiplied by the amount of leverage.
The Interpretation Of Leverage
Leverage is the relation between the size of market position (the purchase price) and trader’s equity. A leverage of 10:1 indicates that you can enter a trade worth $10 by depositing only $1 in equity.
Advantages Of Leverage
Leverage has become extremely popular among traders worldwide due to the following reasons.
First, the use of leverage is fully automated. Each financial instrument has a pre-defined size of leverage, which you can find on the Instruments page. When you enter a trade, leverage is applied automatically.
Second, you do not bear any risk of loosing the borrowed money. Brokers use a stop out mechanism, making the use of borrowed funds absolutely safe for you. You only risk losing your own equity.
Third, the borrowing costs, called SWAP rates, are ultra-low.
Fourth, and the greatest advantage of using leverage is that you magnify your gains (and losses) by using the same amount of equity.
Real Examples Of Using Leverage
Assume, you decide to buy 5 lots of BTC/USD contract. This is equivalent to buying 10 Bitcoins. Assume, the market price is $3,500 and leverage is 10:1.
The trade size will be 5 lots * $3,500 = $17,500.
A leverage of 10:1 means that you need 1/10th (or 10%) of the trade size in equity to enter a trade. In trading platform, this amount will be shown as margin. The other part, equal to 9/10th of the trade size, will be financed by your broker (borrowed funds).
Therefore, to trade $17,500 worth of currency with a leverage of 10:1, you have to deposit only $1,750 in equity (1/10th * $17,500 = $1,750).
Assume that, after you enter a trade, the price goes up by 5%. This will increase the unrealized gain on your account to $875 ($17,500 times 5%). Your equity will increase from $1,750 to $2,625 (equal to $1,750 initial equity plus the gain of $875). In relative terms, your return on equity will be equal to 50% ($2,625 / $1,750 - 1).
As can be seen from the example, you successfully magnified a 5% price increase into a 50% return on equity by using a 10:1 leverage.
Use Of Leverage By Beginners And Professionals
Leverage is used by almost all types of traders and institutional investors. It is applied universally by traders in different asset classes, including cryptos, forex, stocks and futures.
Leveraged trading is highly popular among active individual traders. This includes both beginners and professional traders, trading for their own accounts.
Traders have a wide diversity of trading styles with leverage being an integral component of their strategies.
Some are macro-traders that take longer-term positions based on their views of the underlying economic fundamentals of a cryptocurrency. Such traders prefer to use lower leverage to avoid short-term volatility risks.
Others are high-frequency traders that use technical trading strategies (such as those based on moving averages or Fibonacci levels) and whose trading cycles are sometimes measured in minutes. Such traders prefer high financial leverage, which enables them to extract high profits from small price changes.
Institutional investors, as a separate category of active traders, also utilize leverage in their trading strategies. Such traders include leveraged hedge funds and the proprietary trading desks at banks.
In short, you can benefit from leveraged trading irrespective of whether you are a beginner or a professional trader.
A Downside Risk Of Using Leverage
Although leveraged trading provides a great opportunity to magnify potential gains, it can also magnify potential losses. For example, if a price of a financial instrument moves in a direction, opposite to your market position, leverage will magnify potential losses.
To avoid excessive losses, traders use stop and limit orders.
Taking Advantage From Using Leverage
When you decide to take advantage from leveraged trading on cryptocurrency markets, you must first open a margin account.
Open account at Monfex today and get access to the industry-leading cryptocurrency trading platform. It lets you trade the 5 most liquid cryptos, open long and short positions, and magnify potential gains with up to 50:1 leverage.