There are people out there that are trading bitcoin with just $815 when its price is more than $8000? OK that might have come off as a bit too sell-y, but hear me out. In CFD and Forex trading there is a service most brokers offer called leverage. What is leverage? In extremely basic terms it increases the initial amount that you put forth for a trade. So you can understand all the benefits and of course risks involved with leverage though, you will have to read on.
You won’t be graded in this class but you should definitely take notes. By definition leverage is using a tool to increase force. In trading terms that essentially means being able to make a larger trade with a much smaller initial investment. First and foremost, if you are trading without any risk management it’s like giving a monkey a machine gun – something is bound to go wrong, click the link if you don’t believe me. So now that you have some sort of risk management in place, let’s look into the nuts and bolts of leverage. First: calculation, leverage works like a multiplier, 1:5 means that every dollar is worth five. So a $100 is worth $500. OK that calculation is relatively easy, the next one gets a bit more complex, margin is the capital you need to keep in your account to be able to trade. Leverage becomes a “ratio” in this case so 1/5 = 20% (this percentage is also known as margin) means that you need at least 200 USD to perform a 1000 USD trade. That is important when using leverage, because if the markets move against you and your account goes under $200 than in most cases your trades will be closed.
Most people use leverage in conjunction with stop-loss a risk management tool, to protect themselves from this.
So How Is that Useful?
For example we have seen bitcoin go viral, both on the markets and in the news. Today’s bitcoin price (indicative at the time of writing this article) is above $8100 pushing towards $8200 – how could any normal person trade on that price? Well with a leverage of 1:5 you could trade for just $1620 or with leverage of 1:10 you could trade bitcoin for just $810. The benefit being in the case of a climb of bitcoin, say from $8100 to $8200 you need a fraction of the $8,100 not the entire amount.
So How Much?
Too much of a good thing can be bad and leverage should be treated like that. It can be used within a very disciplined strategy with the correct fail-safes/risk management tools. Also partnering with a broker that offers negative balance protection, will prevent your account from going below zero when trading with leverage. Keep in mind that leverage increases not only your initial investment but your exposure to the market. What does that mean? Let’s assume you use a 1:5 leverage to open a $100 trade (i.e. with an initial investment of $20) compared to a 1:500 to open a $10,000 trade. If the markets move against you your loss will be analogous to your initial investment.