What are the risks of trading with leverage?
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This guide covers all the dangers of using leverage to help you make an informed decision before you start to trade. Read on to learn exactly what leverage is and why you might want to use it, then learn about this investment type and the different ways it can cause you problems and how to use leverage safely.
What is leverage?
Leverage is a form of financial trading that allows you to invest using borrowed money. To make a trade with leverage you have to put down a deposit that’s worth a fraction of an asset’s overall value, and then borrow the rest of the money from your broker.
When you trade with leverage, everything is made more intense and extreme. Small price changes become serious and the value of your investment can change dramatically in a short period of time.
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Why use leverage at all?
There are times when it makes sense to use leverage, such as where the price movements in your chosen market are very small. This is most obviously the case in forex trading, where currency prices fluctuate by fractions of a penny, and you need to make individual trades worth thousands of pounds to make speculating on those tiny changes worthwhile.
In that case, the ability to put down a much smaller amount as a deposit and borrow the rest makes forex trading accessible to the majority of people. Otherwise, only wealthy investors or large institutions would have the financial capital to trade.
Leverage can prove useful in other markets as well. For example, it lets you open lots of positions with a smaller amount of money than might be possible if you had to put down the full value every time. However, in those other markets, where price changes can be much larger than in forex, there can be significant dangers as well.
Why is it dangerous to use leverage?
Leverage can be dangerous because it multiplies the risk of an investment by ensuring that small changes in price can have a dramatic impact on your financial position. It opens up the possibility of losing all the money you invested and it’s particularly risky for beginners who don’t understand how it works.
Although there are risks to most forms of investing, it’s rare for the value of an asset to collapse until it’s worth nothing. It’s unusual for investors to lose all their money and in some cases there are laws in place to prevent that from happening. Even if a company were to go bankrupt, for example, its shareholders might still receive some compensation.
Leverage is a form of derivatives trading, which means you use it to speculate on the value of an asset, rather than owning the asset itself. As a result, if you were to open a leveraged position on Apple stock, you wouldn’t be afforded the same protection as an Apple shareholder who simply bought the stock.
The risk of losing all your money exists even when the price of the asset doesn’t fall to zero. To keep a leveraged position open you have to always maintain the value of the deposit, known as the ‘margin’, and during times of volatility a broker can ask for more. If you don’t provide it, they can ‘liquidate’ (close) the position immediately, taking your deposit with it.
What is liquidation?
Liquidation is what happens if you can’t provide enough of a deposit to keep a position open. It’s the worst case scenario of a leveraged trade, and the risk of it increases with the amount of leverage you use.
The ‘liquidation margin’ is the point at which your position is at risk of being closed. It refers to how much the value of your investment needs to fall before the broker steps in. As a general rule, it’s worked out by dividing 100 by the amount of leverage you use. If you use 10x leverage, the liquidation margin would kick in if your investment fell by 10% (100/10).
This highlights the extreme risk of using high amounts of leverage. If you were to use just 2x leverage, the value of your investment can fall by 50% before liquidation kicks in. Using 10x, 20x, or even more gives you very little room for error and can be disastrous if you invest in assets that regularly see large price swings, such as cryptocurrencies.
How to use leverage safely
You can reduce the risks by only using small amounts of leverage, like 2x or 3x the size of your initial investment, and by only using it in stable markets. That usually means markets in which it’s necessary in order to make money, like forex.
Ultimately, the best approach is to treat leverage as a tool to make your investing life easier, rather than as a shortcut to a quick profit. While it is true that some people have made big bets with leverage that pay off, they are exactly that: bets. It’s never a good idea to borrow money as part of a gamble to make more.
A quick recap of what we’ve learned
Leverage can be a useful tool in certain situations but is much more risky than ‘normal’ investing. Things happen much faster when you use leverage, which can lead to your positions being closed with little warning. Such a closure means the loss of your entire investment and the dangers are much greater in industries with volatile prices. If you’re a beginner, you should steer clear of leverage entirely, and even experienced traders should treat it with caution.
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