Leverage: what it is and how it works

Leverage is an extremely useful tool for investors who have a small amount of capital but want to invest more than they have; or you want to double, triple or more for your profit. However, successfully applying leverage to “make money” is not easy. The following article will explain what leverage is and how leverage amplifies your profit or loss?

1. What is leverage?

Leverage is like a temporary loan offered by a brokerage firm, which allows you to make a trade of many times the value of your trading account to make a substantial profit from small price movements.

For example, you only have 1,000& in your margin account. You want to execute a purchase order with a larger size, that is, $10,000. You can then use the x10 leverage tool to increase your total investment to $10,000.

However, the lever tool is like a double-edged sword. Depending on the level of leverage, the profit or risk increases/decreases and is deducted/added directly to the margin.

2. How does leverage affect profits or losses?

Using leverage can help you quickly make big profits, but it can also wipe out your account quickly.

For example: Trader A and Trader B both use $10,000 of the actual capital in the account to trade.

  • Trader A uses a leverage of x20, increasing the amount to be traded to $200,000.
  • Trader B only uses x5 leverage and the amount he can trade is $50,000.

Case 1: Each trader earns 100 pips

Trader A with x20 leverage will make a profit of $2000, equivalent to 20% in a single trade.

Trader B earns only $500, corresponding to 5% of the account.

Thanks to the use of high leverage, Trader A earns “huge” profits, many times more than the results when no leverage is used or low leverage is used.

Case 2: Everyone loses 100 pips. What’s going on?

  • Trader A will lose a significant amount of $2000, equivalent to 20T% of the account in a trade
  • Trader B lost only $500, equal to 5% of the real capital

Using a reasonable level of leverage, trader B limited the risk of his money. Thus, trader B can continue to trade and earn profits from profitable trades in the future. Conversely, trader A can “burn” the account if the next trade loses.

Therefore, for effective and long-term trading, you need to gain more knowledge and experience to choose a level of leverage that suits your trading strategy.

3. How should you use leverage?

How much leverage should be used?

When deciding to use leverage for a trade, you should carefully calculate and consider the leverage ratio based on the following factors:

  • Trading skill level
  • Risk tolerance
  • The amount of capital

Trading skill level

In trading, there is a principle of “High profit, high risk”. So, using leverage to trade with higher volumes can help you increase your profits many times, but it can also lead to extreme losses if the market goes against your expectations.

Therefore, leverage in general should only be applied to experienced and competent investors and unqualified investors, inaccurate market forecasts and no backup money source, Our advice is not to use leverage (or use leverage x1).

Risk tolerance

Another factor in determining leverage is determining how much risk and how much loss you can tolerate. Venture capitalists tend to choose high leverage, while those with low risk appetite will favor lower leverage.

The amount of capital

Studies have shown that small accounts are more likely to lose money than large accounts. This is because it is easier for small accounts to hit stops. Or it could be because small investors want to make a quick profit. They are attracted by the possibility of large profits from leverage. But they forget that capital can also suffer greater losses if leverage is used. A series of successful trades can be wiped out with a single loss.

How to Limit Risk When Using Leverage

To limit risks and increase profits when using leverage, every trader will have several ways of investing. However, here are the things that every trader should keep in mind with his trading:

  • Start trading with leverage x1. After that the money from successful trades is much larger than the loss from losing trades.
  • Use leverage in moderation. This helps increase profits by keeping losses under control.
  • Use trailing-stop to limit risk and better preserve capital. The trailing stop gives investors more confidence and reduces losses when the market goes against the direction of the initial forecast.
  • Always set a stop loss limit of 1% to 2% of the total account for each order.

It can be said that the use of leverage helps to increase potential profits, but it can also increase losses in the same way. Therefore, every trader must have a plan to choose the appropriate stock leverage level and trading volume. Good luck!

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