Más Idiomas
🌐 English
🇧🇷 Português
⭐️ 中文
Nuestra Academia de Negocios y Economía
Leverage in trading: what it is, how to calculate it and its main uses
Surely you have heard of leverage in trading, one of the basic concepts that everyone should know. Here we will learn what it is, how to calculate it and its main uses in cryptocurrency trading (and other markets, of course).
What is leverage?
Leverage is an investment technique that allows traders to increase potential profits by using borrowed funds to increase the size of their positions.
Commonly used in the currency, equity, commodity and cryptocurrency markets,leverage offers the ability to trade larger amounts than one's own capital would normally allow.
While it can significantly amplify profits, it alsocarries considerable risks, especially for beginners. This is because having borrowed funds 'or on credit' makes it much easier to lose capital.
What is margin and how does it work in leveraged trading?
In leveraged trading, traders only have to deposit a fraction of the total amount of the trade, which is called margin. Intermediaries (e.g. cryptocurrency exchanges) then lend them the rest, allowing them to control a larger position.
Margin is the initial capital a trader needs to open and maintain a leveraged position. It acts as a security deposit to cover potential losses and ensure that the trader can manage the borrowed funds.
For example, using 10:1 leverage, a trader can control $10,000 in assets with a $1,000 deposit. Leverage is expressed as a ratio (e.g., 10:1, 50:1 or even 100:1), and the amount available varies by broker, asset class and regulation.
Exchanges or platforms may also have maintenance margin requirements. If the position moves unfavorably and the trader's account balance falls below the maintenance margin, a margin call may be triggered, forcing the trader to add more funds to keep the position open.
Leverage amplifies both profits and losses (and this is extremely important to keep in mind). When a trade is successful, profits are calculated on the full value of the position, resulting in higher returns compared to using only equity. However, if the market moves against the trade, losses are also amplified, and traders risk losing more than their initial margin deposit.
How is financial leverage calculated?
Financial leverage is calculated by dividing 1 by the value of the total investment and the equity used in the investment. In mathematical terms, the formula would be as follows:
Financial leverage = 1 / (Total investment value / Equity invested).
To better illustrate the calculation, let us take the example mentioned above. If the total value of the investment is 100,000 and the equity invested is 20,000, the calculation is made as follows: 100,000 / 20,000 = 5, therefore, the financial leverage is 1:5. This means that, for each euro of equity capital, the platform contributes.
Advantages of leverage ✅
Leverage can offer several advantages, especially for experienced traders. Key benefits include:
- Increased market exposure: with leverage, traders can access larger positions than they could otherwise afford, allowing for potentially larger profits.
- Capital efficiencyinstead of tying up large sums in a single trade, traders can use leverage to free up funds for other opportunities.
- Greater flexibility: leveraged accounts provide traders with more flexibility, allowing them to enter into more diverse positions or larger trades.
For example, in the foreign exchange market, where currency pairs often move in small amounts, leverage allows traders to profit from even the slightest price movements. Many platforms offer leverage ratios of 30:1 or higher, which can turn small price movements into substantial gains.
Disadvantages of leverage ❌.
Leverage is great for increasing your profits, it also exposes traders to greater risks. The biggest disadvantages are:
- Higher losses: losses can exceed the initial investment, as they are calculated on the total leveraged position. This can be especially difficult for beginning traders or traders with limited portfolios.
- Margin calls: if the market moves against a leveraged position, a broker may issue a margin call. If the trader is unable to add additional funds, the position can be closed, locking in losses.
- Impact of high volatility: in highly volatile markets such as cryptocurrencies, leverage can be very risky. Price swings can quickly deplete a margin balance.
- Interest costs: leveraged positions are subject to commissions or interest overnight, especially in forex and commodities trading. These costs can accumulate over time, especially if a trade is kept open for an extended period, so keep a close eye on it.
How to manage leverage risk?
Risk management is the most important thing in leveraged trading. Here are some strategies that traders can apply to manage risks effectively:
- Use Stop-Loss orders: these orders automatically close a position if the price reaches a predetermined level, thus limiting potential losses.
- Establish a risk-reward ratio: by establishing a favorable risk-reward ratio, traders can better evaluate trades and keep losses manageable in relation to potential profits.
- Diversify trades: avoid putting everything in one asset class. This can reduce exposure to adverse market movements.
- Periodically review leverage ratios: beginners are advised to start with low leverage until they gain experience. Over time, they can adjust ratios as they become more comfortable with market behavior.
