when a trader invests in the financial markets, he mostly uses derivatives which benefit from leverage. Thanks to this leverage or leverage, the investor does not have to block all his capital to benefit from increases and decreases in the price of the underlying asset. To avoid disappointment, it is important to understand the leverage to choose the appropriate level before getting started.
What is Leverage?
Leverage makes it possible to multiply your exposure to a financial market by immobilizing only part of your capital. When making a leveraged investment, the amount needed to hold a position is called hedging. Trading with leverage is sometimes called margin trading.
Leverage exists for many financial products, including spreads, CFDs, and Forex. When you invest in a leveraged product, your broker will only ask you to immobilize a part of the total value of your position. In reality, the broker makes the remaining part available.
Gains and losses are calculated based on the total amount of your position. So the amount you win or lose may seem high compared to the locked-in amount. In a professional account, losses can notably exceed the initial deposit.
Example of Leverage
To give you a concrete example, imagine a 5: 1 leverage and a capital of 5000 dollars (called hedging as part of the leverage). If you want to buy Apple shares for $ 250, you can use a CFD and your investment will be the equivalent of $ 25,000 or 100 Apple shares.
If the price increases by 5%, your profit will be 1250 dollars or 25% of your initial investment whereas it would have been only 250 dollars without leverage. The reverse is also true in the event of a 5% decrease in the share price. You must also take into account the additional costs invoiced by the intermediary, but these are generally minimal in comparison with the potential gain that you get from using leverage.
How to Calculate Leverage
Leverage is calculated by relating the rate of return on economic assets after tax to the cost of debt. Several formulas can be applied, for example: leverage = ( operating profit – tax – financial debt) / equity.
How Much Leverage Is Right for You?
It is very tempting to use high leverage but be aware that this greatly increases your risk. To determine which leverage is right for you, you need to ask yourself several questions. First, you need to assess your level of experience. It is not recommended that a novice trader use significant leverage. Better to get acquainted with the markets first.
Next, you need to analyze your degree of risk aversion. Are you ready to lose the money invested? Is it a long term or short term investment? What are your hopes for performance? Finally, it is important to understand the financial markets and how they work. Markets like the commodities market or cryptocurrencies are known to be volatile.
If you use large leverage in these markets, your risk is maximum. Actions are a little less so, but this can vary depending on a particular context. Ultimately, the right level of leverage should be assessed on a case-by-case basis based on your profile, context, and type of asset.
Rules of Using Leverage
In order to avoid unpleasant surprises, there are two main rules to follow. On the one hand, it is necessary to set up automatic orders of the stop-loss type to limit the breakage in the event of an unexpected fall. On the other hand, it is imperative to diversify your portfolio and also use different leverage effects in order to optimize the management of the risk incurred.
By respecting these two basic rules, amateur traders can more easily avoid cold sweats if the financial markets do not meet their expectations.