What is stock leverage? How does leverage amplifies your profit or loss?
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Leverage is an extremely useful tool for investors who have a small amount of capital but want to invest more than they have; or want to double, triple or more for your profit. However, successfully applying leverage to “make money” is not easy. The article below will explain what stock leverage is and how leverage amplifies your profit or loss?
1. What is stock leverage?
Leverage is like a temporary loan offered to you by a brokerage firm, allowing you to make a trade of many times the value of your trading account to get a substantial profit from small price movements.
For example, you only have 1,000& in your margin account. You want to execute a Buy order with a larger size, namely $10,000. You can then use the x10 leverage tool to raise your total investment to $10,000.
However, the leveraged instrument is like a double-edged sword. According to the leverage level, profit or risk increases/decreases and is deducted/added directly to your margin.
2. How does leverage affect profit or loss?
Using leverage can help you quickly make large profits, but it can also blow your account away quickly.
For example: Trader A and trader B both use $10,000 of the actual capital in the account to trade.
- Trader A uses a leverage of x20, raising the amount to trade to $200,000.
- Trader B uses only x5 leverage and the amount he can trade is $50,000.
Case 1: Each trader earns 100 pips
Trader A with x20 leverage will make a profit of $2000, equivalent to 20% in just one trade.
Trader B only earns 500$, corresponding to 5% of the account.
Thanks to the use of high leverage, Trader A earns “huge” profits, many times more than the results when using no leverage or using low leverage.
Case 2: Everyone loses 100 pips. What happens?
- Trader A will lose a significant amount of $2000, equivalent to 20T% of the account in one trade
- Trader B only lost 500$, equivalent to 5% of the real capital
By using a reasonable level of leverage, trader B has limited the risk of his money. Therefore, trader B can continue to trade and earn profits from profitable trades in the future. Conversely, Trader A may “burn” the account if the next trade loses.
Therefore, for effective and long-term trading, you need to learn more knowledge and experience to choose a level of leverage that suits your trading strategy.
3. How should you use leverage?
How much stock leverage should be used?
When deciding to use leverage for a trade, you need to calculate and carefully consider the leverage ratio based on the following factors:
- Trading Skill Level
- Risk Tolerance
- The amount of capital
Trading Skill Level
In trading, there is a principle of “High profit, high risk”. Hence, using leverage to trade with larger volumes can help you increase your profits many times over, but it can also lead to extreme losses if the market goes against your expectations.
Therefore, financial leverage in general should only be applied to experienced and knowledgeable investors, and unskilled investors, inaccurate market forecasts and no backup money source, Our advice is not to use financial leverage (or use x1 leverage).
Another factor in determining leverage is determining how much risk and how much loss you can tolerate. Venture capitalists tend to choose high leverage, while those with a low risk appetite will favor lower leverage.
The amount of capital
Studies have shown that small accounts are more likely to lose money than large accounts. This is because it is easier for small accounts to hit stops. Or it could be because small investors want to make a quick profit. They are attracted by the possibility of large profits from leverage. But they forget that capital can also suffer greater losses if leverage is used. A string of successful trades can be wiped out with a single loss.
How to limit risk when using stock leverage
To limit risks & increase profits when using leverage, each trader will have different ways of investing. However, here are the things any trader should keep in mind with his trading:
- Start trading with x1 leverage. After the money from the successful trades is much larger than the loss from the losing trades.
- Use leverage in moderation. This helps to increase profits while keeping losses under control.
- Use trailing-stop to limit risk and preserve capital better. Trailing stop gives investors more confidence and reduces losses when the market goes against the direction of initial prediction.
- Always set a stop loss limit of 1% to 2% of the total account for each order.
It can be said that the use of financial leverage helps increase potential profits but can also increase losses equally. Therefore, each trader needs to have a plan to choose the appropriate stock leverage level and trading volume. Good luck!