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Leverage is the use of debt to amplify your exposure to an investment, and it is popularly used by derivatives traders.
- Leverage is offered by the majority of online brokers and you can use it to go long or short.
- By using leverage, you can loan funds from a broker and increase the size of your positions without needing to front the extra capital yourself.
- You should be cautious about overusing leverage because it equally increases your potential exposure to gains and losses.
What is leverage?
It is the use of debt to increase the size of your investment. You can use leverage with stocks and cryptocurrencies that are owned outright. However, it is most popularly and effectively used in conjunction with derivatives like CFDs and spread betting, since they generally offer greater amounts of leverage.
The vast majority of online trading services now offer leverage, and the amount of leverage available can range anywhere from 2X up to 150X on certain platforms. The total deposit you have to put in to use leverage is called the margin, and the lower it is, the greater the level of risk. So, a 5% margin would equate to 20:1 leverage, whereas a 50% margin would equal 2:1.
For example, if you had £5 to invest, and you wanted to increase your exposure to the price performance of a stock, you could use 5:1 leverage to increase your position to £25. This means that should the market go in the direction you desire, you will achieve 5X returns. However, the same applies if the market goes against you.
Considerations when using leverage
In the event that the value of your account is exceeded by your losses, it will be liquidated, meaning you lose everything. As a result, it is strongly recommended that only experienced traders use leverage, and for those that do, they use it cautiously.
When using leverage, the vast majority of brokers charge overnight fees. This is a daily cost that is levied on users for providing them with the money to hold an asset overnight. Therefore, you need to factor this in when calculating trading fees and commissions.
You should also be careful with what assets you choose to trade when using leverage. While volatile markets can provide the price fluctuations needed to have a profitable trading session, they can also result in rapidly escalating losses when using leverage. Generally, the more stable a market is, the safer it is to use leverage. This is why it is frequently deployed to boost trades in the forex market, which has extremely small price movements.
To summarise, leverage allows you to spread your limited funds across a greater number of assets, and it allows you to magnify your exposure to the price movements of any given asset. In addition, markets that offer leveraged trading are usually open 24/7, giving you greater freedom to trade around the clock.
Where can I learn more?
Fact-checking & references
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