Leverage is a tool used in trading to increase investment capacity without requiring a capital increase. This financial concept makes it possible to open positions much larger than the capital actually held in a trading account, thus amplifying potential gains but also losses with the risk of total liquidation.
What is leverage?
Leverage is a financial concept that allows traders to increase their investment capacity through debt.
This mechanism, often seen as a double-edged sword, allows you to increase equity using borrowed funds under certain conditions.
In practice, it allows traders to open positions that are significantly larger than the amount of capital they own, giving a multiplier effect and to gain exposure to large amounts of securities, currencies, cryptocurrencies or other financial assets..
Leverage in trading represents the ratio used to determine the amount a broker gives to a trader relative to their initial deposit.
E.g, a leverage of 5 allows a trader to open a €1,000 position with €200 in equity :
Leverage is offered by brokers offering, for example, CFDs, and works through a virtual loan where the trader does not borrow funds directly, but opens a position whose value is higher than his capital.
The initial deposit, known as “margin”represents a fraction of the total value of the open position.
Be careful with leverage
Be careful, using leverage involves high risks and is mainly suitable for experienced traders. It is important to note that while allowing for exponential profits, leverage can also lead to significant losses, potentially leading to a complete liquidation of the capital involved.
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Example of leverage with a cryptocurrency
A trader opens a €100 position with 1:2 leverage in Bitcoin (BTC). It means that the total amount actually invested in the market is €200.
If the value of Bitcoin increases by 10%, the trader’s position is then worth €220 (€200 * 10%). The profit that the trader has is therefore €20.
However, using leverage involves high risk as potential losses are also magnified. If Bitcoin loses 10% of its value, the trader’s position drops to €180 (€200 – €20). The loss is therefore €20, which corresponds to 20% of the trader’s original amount. If the loss continues up to 50% of the original value of Bitcointhis corresponds to the trader’s total initial amount. The trader’s position is then “liquidated”.
Example of leverage in Forex
A trader uses leverage of 1:5 to invest in the EUR/USD currency pair on the Forex market. For every euro invested, the broker then borrows an additional €5.
Therefore, if the EUR/USD currency pair increases by 1%, the trader multiplies his profit by 5. However, if the pair falls, the losses are also multiplied by 5, illustrating the risky nature of leverage.
Example of leverage on the stock market
Let’s say a trader wants to invest in shares of a company which trades at €10 per share. stock.
Without leverage, with a capital of €1,000, the trader could buy 100 shares.
Using 2:1 leverage, the trader could control 200 shares with the same starting capital.
If the share price increases by €1, the original investment would make a profit of €100 (10% return), while the leveraged investment would make a profit of €200 (20% return).
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You must be aware of the many dangers of leverage
Although the use of leverage offers significant benefits, such as profit amplification and increased investment capacity, it is also associated with significant risks.
Yes, traders expose themselves to risks of amplified losses by using leverage. Just as it can increase profits, leverage can also cause losses, potentially beyond the initial capital invested..
When the value of the loss equals the value of the initial capital invested, the position is “liquidated”. This means that the open position is automatically sold by the trading platform and the invested capital is permanently lost.
In addition, leverage exposes investors to margin calls: if a position moves against the trader, the broker may demand a ” margin call,” which requires the trader to provide additional funds to keep the position open. Too much debt can lead to insolvency.
To mitigate the risks associated with leverage, investors and traders can adopt various strategies, such as diversification of investments, use of financial products with limited risk and a thorough analysis of the profitability of the investments considered. Also, the use of stop losses, profit limits and a strict trading strategy are essential to protect your investment capital.
It is important to remember that Trading is a profession that requires knowledge and experience. The use of leverage cannot be improvised and is generally reserved for those who have fully mastered market mechanisms.
If you have no experience as a trader, it is therefore advisable to choose a long-term, more stable and potentially less risky investment approach. This allows you to gradually build your investment portfolio while limiting the risk of significant losses.
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Driven by the design of economic models in blockchain projects, I put my expertise in tokenomics at the service of project creators who shape the world of the future. My enthusiasm for sharing ideas and exchanging knowledge is guided by the goal of building an innovative and decentralized future where blockchain technology is synonymous with progress and sustainable innovation.
Mathilde Michels
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