Leverage: trading with leverage explained
When you invest you can apply leverage. But what is leverage? Simply put, leverage makes it possible to make a larger investment with the same amount of money. This allows you to take greater advantage of price fluctuations. But how does leverage work and what are the risks of trading with leverage?
What is leverage?
When you invest, you can use leverage whenever you want. Leverage is always displayed as a ratio, for example 1:30. When the leverage is 1:30, this means that you can trade with $30.000 by investing only $1,000. Leverage makes it possible to open larger trades.
Where can you trade with leverage?
Many brokers offer the possibility of applying leverage. Usually CFD’s are used for trading with leverage. You can easily apply leverage by trading with a larger amount than you deposited in your account. Do you want to know which brokers offer trading with leverage? We’ve listed the best parties for you:
The effect of leverage: some examples
When you apply leverage, your potential gains and losses increase significantly. When you buy a stock for $10 you can achieve the following results:
- With an increase of $1 you get a profit of $1.
- If the stock drops $1, you will achieve a loss of $1.
When you apply a 1:10 leverage, you get other results:
- With an increase of $1 you get a profit of $10.
- If the stock drops $1, you will achieve a loss of $10.
Later in this article we will show how leverage works by using a more comprehensive example.
How does leverage work?
You can use leverage with an online broker. Here you see an overview of online brokers where you can trade in stocks with leverage. After opening an account you can directly use leverage. You apply leverage by investing more money than you deposited on your account. But how is the leverage handled within your investment account?
Leverage can be compared to a loan. The broker finances a large portion of the purchasing price and the difference between the opening and closing price will eventually be settled in your account balance. You are never the owner of a stock; the broker will take care of both buying and selling. When trading CFD’s, you don’t have any other responsibilities because you’re never the owner of the stock.
Example of trading with leverage
In this example, we assume that you have $1000 in your trading account. You decide to buy shares for this amount at a price of $10. The price increases during the day, and when the price hits $12 you close the position again. What would be the results of these investments with and without leverage?
Without leverage: the price has risen $2 and for $1000 you could buy 100 shares. These 100 shares have increased in value by $2. Your total profit in this case is $200 or 20%.
With leverage: you decide to apply a leverage of 1:10 to your investment. You can now buy shares for $10,000. You can open a trade on 1000 shares. These shares have increased in value by $2. Your total profit in this case is $2000 or 200%.
As you can see, in this case you would make a larger profit by using leverage. Remember, however, that the same could have happened in the opposite direction. If the price had decreased, your loss would have been larger when you would apply leverage!
Benefits of high leverage
A big advantage of leverage is that you can make larger investments with a low amount of money. You do not need to have the full value of your trade on your trading account.
A second advantage of a leverage is that it is easier to speculate on small price changes. By using leverage you can earn more money from a small price increase. This makes active trading more interesting.
Leverage financing costs
You always pay fees to use leverage. These costs are calculated in the form of financing costs. The broker finances a large part of the investment when you apply leverage. You have to pay interest on this amount. The amount of interest you have to pay on your leverage may vary by broker and by investment product.
Investing with leverage is therefore only attractive for investments in the shorter term. Do you want to make a long-term investment? Then it’s smarter to buy shares and to hold on to them for a longer period of time.
Be careful when using leverage!
Higher leverage also brings higher risks. With leverage your loses increase faster than without leverage. Remember that the leverage effect works in both ways. You should therefore use leverage responsibly.
When you just start trading it is wise to avoid using high leverage. Only when you understand how you can make money with trading it is wise to start applying leverage. When you use this powerful tool correctly you can increase your profits enormously!
When you use leverage you must have enough money available on your account. Brokers apply a maintenance margin which indicates the amount you need on your account to keep your trading positions open. When the amount in your account is no longer sufficient to keep your positions open, you will receive a margin call. This can result in losing your full investment!