How to choose the right leverage for your trading
A powerful tool that’s often ignored or misunderstood by beginners, leverage is key to CFD trading offered by ActivTrades. Knowing how to choose the right leverage for your trading can help you minimize your risks while ramping up your trading. Let’s have a look at what leverage is, what its benefits and limits are, as well as how you can best manage your funds when trading with leverage.
One of the reasons why so many novice traders fail at leverage trading and lose money is because they don’t really understand how leverage impacts their trading, and they’re often undercapitalized when they start.
So, what is leverage exactly?
Leverage in trading can simply be described as the ability you have as a trader to invest more money than you own in your account by borrowing from your broker, so then you can take advantage of exposure to larger trades.
One of the greatest advantages and risks of leverage is that it amplifies and magnifies price movements, which means that you can make larger profits if markets go in your direction, but you will record bigger losses if they go against you.
To be able to get extra money to trade and open positions, your broker will ask you to put a certain amount of money as a “good faith deposit” or “collateral” called the margin. The margin is usually represented by a percentage of the total value of your position.
Impact of leverage on your trading
With the margin requirements of your broker, you can easily determine the maximum leverage you can use in your trading.
For instance, if your broker requires 0.25%, 1%, 2%, 5% margin on the asset you want to trade, then you can get a leverage of respectively 400:1, 100:1, 50:1, and 20:1.
The higher the leverage, the lower the margin required and the more leverage you use, the riskier it is for your trading capital.
If you make a 5% profit using 100;1, 30:1, 10:1, or 2:1 leverage, then your gain will be 500%, 150%, 35%, or 10%. If you’re wrong and the market moves against you, these percentages will be your loss.
It’s also important to take into account the fees applied for trading on margin. Usually, the higher the leverage, the bigger the fees.
Financial products offering leverage
There are different financial products offering traders a chance to trade using leverage:
- Contract For Difference (CFD)
- Spread betting
- Exchange-Traded Funds (ETF)
ActivTrades offers more than 1,000 CFD or Spread Betting instruments across different markets like Forex, Commodities, Indices, Financials, Shares, and ETF to traders in more than 140 countries.
Pros of using leverage in your trading
- As it amplifies market movements, you can potentially earn more money with leverage and margin trading (but the risks are equally amplified).
- Leverage allows you to start with a relatively small amount of trading capital and get more market exposure than otherwise possible.
- You can better diversify your portfolio by trading numerous markets at the same time.
- As you mostly use derivatives like CFDs to trade with leverage, you can benefit from the rise and fall of markets.
- Depending on which markets you focus on, you can potentially trade non-stop, even during pre-market and after-hours trading.
Risks of using leverage in your trading
- Leverage is a double-edged sword and can magnify both profits and losses, which means that the risk of losing money is elevated.
- When trading with leverage, you do not own the underlying financial asset.
- As you’re using borrowed funds with leverage and margin trading, you have to pay funding fees. If you keep your trades overnight, you will also have to pay overnight, swaps or roll-over fees.
- If you’re wrong about the direction of a trade and your losing position triggers your capital to fall below the minimum amount required to keep a position open, then your broker will issue a margin call and ask you to fund your account to keep your position open.
How much money can you invest with an initial amount of £1,000 using leverage?
- Leverage of 1:1 = £1,000
- Leverage of 10:1 = £10,000
- Leverage of 20:1 = £20,000
- Leverage of 50:1 = £50,000
- Leverage of 100:1 = £100,000
- Leverage of 200:1 = £200,000
How to pick the right level of leverage for your trades
To choose the right leverage for your trading, you first need to understand how leverage can help you.
You also need to take into consideration your overall trading knowledge and experience, your financial goals, your starting trading capital, as well as your trading strategy and style (scalping, day trading, swing trading), as leverage isn’t appropriate for all types of trading.
It isn’t a great option for “buy and hold” types of investors that will use longer timeframes and invest over the long-term, for instance.
The leverage ratio and margin requirements from your broker, the traded markets and the potential size of your positions, as well as applied risk and money management rules will also help you pick the right leverage for your trading.
Tips about how to best use leverage in your trading to avoid unnecessary risks
- The first tip might seem obvious, but most beginners start using leverage products without really knowing what they are. So, take the time to understand what leverage truly is, how it works, and how you can make the most of it in your trading.
- Leverage is a very popular tool, but do not take its use lightly, as it can quickly wipe out your trading capital if misused.
- Choose a regulated broker that allows you to quickly change your leverage if you need to.
- Adapt your leverage to market conditions.
- If you’re a beginner, start with the lowest leverage.
- Adjust the size of your trading positions and how much money you want to commit to each trade according to your capital, leverage, experience, and market volatility.
- Always use a stop-loss to better protect your trading capital and reduce downside risk.
- Avoid allocating more than 2% of your capital to a single trade.
- Use specific tools to help you understand the impact of leverage on your trades, like the ActivTrades Smart Calculator and adopt better money management rules.
- Start with a demo trading account to trade with virtual funds in order to find out what the best leverage for your trading is.
Hopefully, you now have a better understanding of what leverage means and how you can optimize its use in your trading to maximize its potential and minimize its risks! How about testing your strategy and selecting the right leverage on our trading platforms by opening a trading account at ActivTrades?
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