Financial leverage: a complex instrument and not for everyone
Leverage meaning is often demonised and viewed with extreme fear.
Novice traders and investors avoid it regardless. Or they do the exact opposite, employing it without planning and taking big risks.
Those with more experience, on the other hand, know how useful it is. As with anything, the important thing is to know the specific instrument thoroughly.
In this in-depth look at what leverage is, how it works and when it should be used. We will reiterate its name, because it is not something dangerous a priori, on the contrary: sometimes it makes a difference in a positive sense.
At the same time, however, we will warn of the risks involved in its use. In fact, there is no shortage of critical points to bear in mind.
Leverage is an advanced instrument and should not be considered by those with little experience behind them. So, if you are new to the world of trading, read the following, treasure it, but take your time before using it in your trading.
The considerations we will make will be valid for a variety of markets: from cryptocurrencies to other financial instruments such as derivatives and Forex.
OK, let’s not dwell on it any longer, let’s get to the heart of the matter and understand what leverage is.
Index
What is leverage?
Leverage (sometimes also called trading leverage or more commonly leverage) is an instrument that allows one to increase one’s exposure in the market from a smaller capital.
By trading with leverage, the investor only puts up part of the value of the position. The rest is borrowed from his broker. For example, by using Bybit, the latter will provide the necessary capital.
By leveraging your positions, the potential profit will not only be based on the amount we put in, but on the entire amount of the position. Thus, by providing 100€ from our own pocket but operating with a total of 500€, the profit will be proportional to this amount.
As can be guessed, however, this mode also works in reverse: any loss is calculated on the €500 of the position, not on the €100 we deposited. Thus, the effect amplifies both positive and negative movements, and therein lies the danger of leverage.
OK, there is the possibility of making good money but also of losing a lot of money. Why should we take risks? What is the usefulness of this tactic?
First of all, let us see when you should not use leverage trading.
It should be avoided if you do not have trading experience and knowledge. Being a double-edged knife, leverage requires the right preparation to avoid hurting yourself.
Next, this tool should not be used to open random positions, trusting in an easy profit. If we were expecting a bitcoin super-pump, it would still be ill-advised to enter into a highly speculative transaction using leverage: it would only take a small movement to the contrary to eat up all the capital we provided… and more!
In the next few paragraphs we will discover the mechanics of leverage, so that we can understand how easy it is to lose money if you don’t plan everything very carefully.
First, however, let’s see when a leveraged investment might be right for us.
The answer is easier than you might think: whenever our analyses show that it would make sense to do so.
Leverage is powerful and beneficial when practised head-on. It is a valuable ally for small investors with little capital who would require numerous positive trades to generate a significant profit. By expanding their positions through leverage, these individuals can move significantly larger sums and take home the resulting gains.
In addition, according to one’s risk management plan, it is sometimes necessary to invest leveraged precisely in order to comply with the calculations made on a particular trade. You will find a practical example in the video at the end.
If, on the other hand, you’re just starting out and don’t know what risk management is, that’s no problem. The following film is the first chapter of our course on risk-aware trading, which was created to help you get to grips with the basics of risk management.
Now that we have a basic grounding, we can proceed further. Let us now discover financial leverage and its characteristics in more detail
How is leverage calculated?
Let’s say we have 100€ to invest in trading a certain asset. We could do this in two ways:
- Trade with this sum;
- Use leverage to optimise the potential gain.
In the first case, no matter how good and capable we are at analysing the market, the return will always be modest: 20% (a very positive performance) will only get us 20€. Leaving aside possible commissions that would bring a smaller amount into our pockets.
If used well, leverage can give us a big hand.
In this scenario, we could invest our 100€ and use 10x leverage (or 10:1 levas ratio if you want to be more technical). By doing so, the position we are going to open will be as much as 1000€, for an outlay of only 100 (10% of the total). The sum ‘put into play’ by us is called margin.
In the event of a positive outcome, let us always assume 20%, the profit will correspond to a good 200€. In reality, thanks to leverage, this percentage will be 100% of our margin.
To recapitulate:
- In the first case, the 20% growth of the asset leads to a gain of 20% of our capital;
- In the second case, the same performance of the asset leads to a 20% gain on the entire position (1000€ + 20% = 1200€). Thus, a good 200€ will end up in our pockets, exactly double the margin used.
Therefore, leverage is a great tool for boosting income, as long as it is well planned. It is the ideal solution for those who do not have a lot of funds because it allows them to maximise their gains.
Of course, there is also the flip side of the coin. We anticipated it: leverage works both good and bad. Just as it amplifies income, leverage can at the same time multiply losses.
And yes: being positioned with leverage capital, it only takes a small swing to burn our entire margin. Obviously, the more aggressive the leverage, the higher the risk: a 2x leverage is definitely softer than a 10x leverage. So there is no precise answer to ‘how much leverage should it be?’: apart from the fact that we should never overdo it, everything depends on the calculations.
With a margin of 100€ and an open position of 1000 (10x leverage) all it takes is -10% of the asset to blow our capital. An event of this magnitude is not so rare in the world of cryptocurrencies. Close to the point, liquidation is triggered: the broker who provided us with the loan protects himself and closes the transaction, so as to protect himself from the risk of insolvency. This situation should always be avoided: liquidation entails quite substantial extra costs.
Therefore, be very careful and never consider only what is positive. On the contrary, we should first think about the risks and only then focus on the opportunities.
Leverage calculator
Now that we know the leverage definition, let’s see how to calculate it.
Almost every trading platform provides a leverage calculator. However, it can also be done manually by performing simple multiplications.
For example: 10x leverage with 100€ margin equals 1,000€ invested capital. The 10% growth of the asset will lead to a 100% gain (because you multiply x10); at the same time, the -10% will eat up all the margin.
Pros and cons of leverage
Let us move on to an examination of the main pros and cons of leverage.
Among the advantages, it is impossible not to mention the superior availability of capital. Leverage allows us to move large amounts of money for a small margin, benefiting from potentially higher returns.
At the same time, this instrument allows small investors to trade in otherwise inaccessible assets. This is because in some cases minimum amounts are required to open positions: without large starting capital, leverage is the only solution. In fact, it opens wide the doors of the most elite markets.
Inevitably, having greater funds leads to equally greater gains. As seen briefly in the previous section, the returns can be very tempting.
A well-planned leveraged position can also be a valuable tool in low-volatility markets, where percentage changes move much more slowly. It is one thing to take home 1% on 100€, it is quite another to do so on 1000 or 10000. Of course, if you have large funds at your disposal, leverage takes second place.
Not to be forgotten is the value of this instrument inhedging operations: margin trading is a great way to hedge against market shocks. The famous hedging short on bitcoin is an example.
More generally, leverage has the advantage of being a very useful tool in the ‘toolbox’ of the experienced and careful trader. Employed where it is needed, it helps to build profitable investments over time.
Let us turn, however, to the cons. We have said that the positives must be measured alongside the negatives; let us see what they are.
First of all, we will not tire of emphasising how leverage works in both directions. Movements against our position result in amplified losses. Let us not only look at the opportunities but also carefully observe the downside.
Moreover, if the leverage is aggressive or the variation is marked, the danger of being liquidated is well present.
The non-improvised trader is well aware of this and protects himself immediately, for example by setting a stop loss not too close to the liquidation price. In short, there are methods to cover oneself and sleep soundly.
We could sum up the last two points in one sentence: the cons of leverage is that it requires experience and knowledge of the instrument itself. Using it haphazardly, without fully understanding its mechanism, almost always leads to great harm.
"Leverage does its job both good and bad: handle with care!"
Leverage: opportunity or danger?
Summing up, now that we understand how leverage works, is it right for it to be viewed so unfavourably? The answer is no.
Like any instrument, leverage has advantages and disadvantages. When used with a head and by people with some experience, it is something positive.
Of course, there is still the possibility that things will not go as planned, that is part of our world. The important thing is to start off on the right foot and minimise this possibility. After that everything will depend on the market: if we had seen it right we will be rewarded, otherwise we will suffer a loss. However, by setting the action correctly, leverage will not destroy our finances.
When employed without careful study, however, leverage is very dangerous. This is true in any market we trade, from cryptocurrencies to equity derivatives. No one wants to see their savings go up in smoke: why risk it if you don’t have the knowledge?
Therefore, study is a must.
Many free materials are available on our portal, ranging from technical analysis to a real knowledgeable trading course on our training platform. In addition, as always, the YouTube channel is full of content ready to be consulted.
We close this in-depth look with a video dedicated to leveraged bitcoin trading, where I illustrate a practical and easy-to-understand example. Enjoy watching!
