What is leveraged trading and how does it work?
Ever heard of the term ‘leveraged trading’ or ‘indices trading’? In the financial world, these commonly used terms by both investors and companies. Investors use leverage to significantly increase the returns that can be provided on an investment. They lever their investments by using various instruments that include options, futures and margin accounts. Companies can use leverage to finance their assets. In other words, instead of issuing stock to raise capital, companies can use debt financing to invest in business operations in an attempt to increase shareholder value.
The main focus of our article is to understand the concept of leveraged trading better, and how investors make use of it to earn favorable returns.
What is leveraged trading?
To begin with, let us first understand the concept of leverage. Leverage refers to the use of borrowed capital to increase the exposure that an investor faces. In the hopes of earning a higher return than what an investor would be able to earn given the original capital put in.
Leverage Trading refers to making trades in the financial markets using leverage. You put up an initial sum of capital, and that allows you to leverage to take up a much bigger position.
Types of leveraged products
There are many different types of leveraged products. The most common product that people are familiar with is Foreign Exchange (Forex) trading.
Forex trading refers to the market in which currencies are trading. Currency trading works in pairs. For example, a trader can take up a position in the EUR/USD. They can decide whether the US Dollar will appreciate or depreciate against the Euro, and vice versa. They make money if they are right on the trade, and make losses if they are wrong.
Contract for Difference (CFD)
CFD refers to an arrangement made in a futures contract whereby differences in the settlement are made through cash payments, rather than by the delivery of physical goods or securities. This is generally an easier method of settlement because both losses and gains are paid in cash. CFDs provide investors with the all the benefits and risks of owning a security without actually owning it.
How to manage leverage
Managing leverage is a tricky skill. It will require you to manage risk effectively to avoid making huge losses. Imagine you have wanted to pay a deposit of $ 5000, and you end up borrowing $ 20,000 instead. You will be left with excess cash, which you can then choose to invest effectively to either make a profit or loss. Here, the way to manage risk would depend on where you choose to invest your surplus cash. If you opt for FOREX trading, then the risk is determining how much trading capital is available with you.
But of all the risks inherent in a trade, the hardest risk to manage, and by far the most common risk blamed for trader loss is the bad habit pattern of the trader himself.
All traders have to take responsibility for their own decisions. In trading, losses are part of the norm, so a trader must learn to accept losses as part of the process. Losses are not failures. However, not taking a loss quickly is a failure of proper trade management. Usually, a trader, when his position moves into a loss, will second guess his system and wait for the loss to turn around and for the position to become profit.
One of the key benefits of FOREX trading is the high leverage that comes with it. This high leverage is available because the market is so liquid that it is easy to cut out of a position very quickly and, therefore, easier compared with most other markets to manage leveraged positions. Leverage of course cuts two ways. If you are leveraged and you make a profit, your returns are magnified very quickly. But, in the converse, losses will erode your account just as quickly too
All financial products can be risky for investors and traders if the process of risk management is not taken seriously. Even trading treasury bonds, which the average investors would deem as safe, can be risky if a person is ignorant of the risks involve. The same can be said for leverage products.
Leverage is a double-edged sword. On one hand, traders need to utilise it to increase their exposure and profit on instruments that may otherwise not move by much. At the same time, the leverage could potentially translate into bigger losses as well.
A 1% movement in currency would just be a 1% loss of capital if no leverage were employing. With a 50:1 leverage, however, that could result in a 50% loss on capital. Traders need to be familiar with the instruments they are trading, their current position and how much leverage they are employing.
The concept of leverage is a complex one and we hope this brief has managed to draw light on the basics of leveraged trading.
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