The world of financial trading has the ability to captivate, intrigue, and inspire all at the same time. It is a profession that is celebrated during the boom times and vilified when the market drops, and it’s also one with plenty of interesting lessons to share. Whether you actively trade, are thinking about it, or just want to broaden your horizons, thinking about how leverage changes the balance of risk and reward can be insightful.
In this guide, we’re going to take a look at what it means by looking at leveraged trading in the context of the forex and crypto markets.
What is Forex Trading?
A forex trader is someone who deploys strategies that are designed to generate profits from changes to exchange rates. In simple terms, they buy one currency, sell another, and look for times when the exchange rate is in their favor. There are also more complex options where traders can make bets about how certain currency pairs will behave over time. Forex traders will use a regulated forex broker to access these types of markets.
What is a Crypto Market?
A crypto market is where traders trade different crypto currencies with the aim of securing profits. They work much the same as trading other assets, with the aim always being to buy low and sell high. Traders will often look to diverse markets so that they can trade different assets and reduce the overall risk profile of their trading portfolios. Many traders will also use leverage so that they can take up much bigger positions than they otherwise would be able to.
What is Leveraged Trading?
When a trader employs leverage, they are borrowing capital from their broker to multiply their profits from winning trades. The advantage is that they can make more money while holding much less capital, but the downside is that they are also amplifying the losses of losing trades. Leveraged trading is higher risk and higher reward, and is how many institutional traders go about executing their strategies.
Managing Leveraged Risk
The most important thing to note about leveraged risk is that you can lose more money than you have because you will also need to repay the loan to the broker. Traders who become reckless or fixated on a single market or asset expose themselves to rapid losses that can quickly get out of control. With this in mind, there are a number of ways that leveraged trades can be partially derisked:
- Diversification of trading portfolios means that a bubble in one market cannot generally burst and wipe out the trader.
- Setting stops beyond which the trade automatically ceases and the position is closed will stop losses mounting indefinitely.
- Putting price alerts in place will notify the trader of unexpected market behavior and give them time to react accordingly.
Traders who want to make use of leverage are also well-advised to ensure they are sufficiently capitalized in the first place. Borrowing more from the broker than you can reasonably afford to repay leaves you exposed to undue risk. Different situations can be tested using a demo trading simulator.
Enhanced Rewards with Leverage
It’s important to know that the loan the broker provides needs to be serviced by regular interest repayments. This means that to hold a position for an extended period of time, traders will need to take into account the size of the interest payments they need to make. When they come to close the position, they will have to repay the loan plus any interest that has been outlined in the loan agreement. The money that remains is then the profit from the trade.
Strategic traders will typically have formulas for what percentage of their profits they will pull out and what percentage they will put back into the market. Consistently reinvesting everything can be tempting, but it keeps the trader exposed to the full extent of the market’s dips. A balanced approach that pulls out profits and reinvests at a higher rate is often the best approach to take.
Calculating Leverage Ratios
The total value of the trade divided by how much capital you can supply before borrowing gives the leverage ratio. Alternatively, you can think of leverage as the multiple of your capital that you are borrowing. If you look to put down $1,000 and borrow $20,000, you’re trading at 20:1. Ratios of this size are seen as conservative, with some traders who are backed by institutional funds pushing leverage as high as 500:1.
Leveraged trading is something that can feel highly tempting for new traders, but it’s also something that needs to be approached with caution. Understanding the mechanics and behavior of the forex or crypto market you are trading in requires careful analysis. Leveraged positions should only be adopted when the risk profile is aligned with the rest of the trading portfolio and the capital that is held in reserve.
Leverage & Short-Term Volatility
A market that is rapidly changing behavior is volatile, and volatility can complicate the execution of leveraged trading strategies. Short-term rises and falls in the value of a position will be amplified by the use of leverage, increasing the pressure on less-experienced traders. The key here is to focus on the value of the leveraged position across multiple timeframes. That way, you will be able to understand the global direction the market is tending rather than feeling pressure to exit due to a dip right at that moment. Trading across multiple asset classes and timeframes can help make a portfolio of leveraged positions more robust.
Final Thoughts
Leverage unlocks the possibility for significantly larger profits, but also exposes the trader to a higher level of risk. Leveraged positions that are held long-term will need to be serviced by interest payments, which in turn eat into future potential profits. Strategies that use leverage need to be driven by analytical data and backed by a large amount of reserve capital. Traders will also adjust the amount of leverage they use across their portfolio to distribute their risk exposure.
Founder Dinis Guarda
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