Do you want to use leverage to succeed in trading?
Who does not?
In fact, leverage is one of the keys why this activity is so sought after and popular in the world.
I think I am not mistaken if hundreds of millions of people do online trading from time to time.
In some countries such as the United States, Japan, and the United Kingdom, the use of online trading with leverage is very common.
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Other countries like China or India are increasing the number of traders and almost all of them have something in common: they want to trade online using financial leverage.
It is understandable.
If it weren’t for leverage, the interest in online trading would not be a tenth of what it is.
First let’s see what this is about financial leverage on the stock market.
Definition of financial leverage
Financial leverage is the use of credit or borrowed capital to make investments or purchases at the present time.
In other words, we are talking about a credit or debt instrument.
Financed purchases of homes and cars are thus leveraged purchases, where the consumer or investor (depending on how you look at it) buy the asset, putting only a small part of the sale price on the table.
For example, if we buy a house for 200,000 euros and put 5,000 as an initial deposit, we would be using financial leverage.
This is so because the bank lends us the rest in exchange for future remuneration.
Well, the leverage in trading and the stock market is something similar but with some nuances.
The broker lends us an amount of money to operate certain assets.
This amount will be returned to you under the stipulated conditions.
Let’s see an example:
I have $ 100 in the account and buy 2,000 USDJPY.
I have done so thanks to the fact that the broker has provided me $ 1,950 for it.
When you sell that position the broker will recover the money.
If the broker sees that the position is going to drop below $ 1,950 in value, it will make us known as the “margin call” ( there is a movie called that too), which would be a kind of “leverage call”.
This is done to avoid incurring losses on that initial loan.
In those cases the broker liquidates the operation before the limit is reached and thus they even do us a favor because otherwise we could lose more money than we have deposited in the account (which could happen in some extraordinary case but which is not common).
As you can see the leverage can mean that we earn a lot of money or that we lose a lot of money too.
If we have an account in which we manage an amount of money ten times greater than the deposited, we can have a profit of 100% (double our money) if the asset in which we are invested rises 10%.
If, on the contrary, that asset falls by 10%, we will have lost 100% of our investment.
Do you see the power of this concept, yes?
Leverage on the exchange is also known as margin , a term that is widely used in the American equity markets (margin).
That leverage is offered for the vast majority of trading or investment vehicles that exist today.
We have 1: 1 leverage, as in the case of stocks, and we also have 500 or 1000: 1 leverage as in the case of some forex brokers or cfds.
That is, if we want to buy € 10,000 in a share we will have to have the same amount of money in the account to be able to do it.
By contrast, American brokers offer the possibility of using margin to trade in stocks, although not all.
If we do intraday trading we will be able to use a 4 to 1 (4: 1) leverage, and if we keep the operations open after the close of the session we will be able to have a 2 to 1 leverage.
In order to use more leverage we will have to choose other alternatives.
Stock leverage with regulations: ESMA case
In recent years, there have been a series of regulations that have greatly limited leverage in some of the most important countries and regions in the world.
The most notable cases were those of Japan, the United States and Europe, which placed limits on the operation of Forex and CFDs alleging that the leverage was too high and very risky for traders.
The United States applied a maximum leverage of 50: 1 for the Forex.
Later Europe applied the famous ESMA regulation with a maximum of 30: 1 for the most liquid Forex pairs.
The vast majority of traders in these regions complained bitterly, citing many reasons as “freedom of action.”
The truth is that these regulations have some positive aspects but others negative ones.
On the negative side, they have caused great harm to the industry in their regions, as competition abroad has benefited.
For example, look at the case of Australian or Swiss brokers.
On the positive side, they have made it much longer for traders to lose money, because we recognize one thing: the vast majority of traders lose. And of course, it is not the same to operate with a leverage of 100: 1 than 20: 1.
In the first case you are going to lose money faster.
Leverage is still adequate for trading with quite a bit of risk, although in the European case I think they have raised the bar too much in some instruments.
Let’s look at the leverages in the different financial products of online trading.
This is a case where it is difficult to find leverage.
Being such a wide and varied market, there are not too many instruments that can offer the same liquidity and ease of trading as others in markets more suitable for day trading, such as futures or Forex.
In addition, we have that many of the stocks have large movements after-hours (after closing) quite frequently, hence the brokers are reluctant to provide large leverages.
Generally we will have to operate without any margin.
In some other European broker you can find a leverage of 1.5: 1 or 2: 1.
Also we can find some international brokers that provide this margin.
One of the best known cases is that of Interactive Brokers , but in this case you must have at least $ 25,000 in the account, in which case we can operate with a margin of 4: 1.
In CFDs we can use leverage to buy any instrument.
CFDs cover the operation of any known financial instrument, from stocks to commodities, through currencies and bonds.
Depending on the regulation we will have different options.
In Europe we will be limited to ESMA regulations with maximum leverage of:
- Main indices and gold: 20 to 1
- Minor indices and raw materials: 10 to 1
- Actions: 5 to 1
Outside of Europe, where you can trade without these restrictions, you can find a higher margin, typically 10: 1 for stocks and 50 or 100: 1 for indices and gold.
It is above all in the group of indices and raw materials that international brokers and clients have a great advantage over Europeans.
For example, a Chilean trader would prefer to open an account with a broker that offers 50: 1 on the SP500 than with one that offers 20: 1. This is on equal terms.
My experience as a market trader tells me that we don’t really need such large leverages, but that’s also because my technique doesn’t require it.
Other high-frequency techniques prefer high leverage.
Each one will have to choose according to their preference.
Futures offer the possibility of trading with strong leverage as well.
One of the most widely traded and known futures in the world, the SP500 mini, called ES, offers the possibility of trading with a daily margin of $ 400 and 5,000 if we want to leave the position open overnight.
Taking into account that, according to the price of the SP500, the nominal of the contract can be around $ 100,000, we would be talking about leverage of 250 to 1 intraday and 20 to 1 in medium or long-term trading.
As you can see the difference of doing intraday with the future of the SP500 and with the CFD of the same asset has become abysmal.
So CFD brokers used to offer 100 or 200: 1.
Not because it was something abnormal, but because it is what is offered in the reference derivatives markets in world financial markets: futures.
In the forex we can find huge leverages.
It is not uncommon to find brokers that offer leverage of 400: 1, 500: 1, 1000: 1 or even 3000: 1.
This makes forex one of the favorite instruments of day traders, because in it the leverage facilities, together with the flexibility in contracting make it ideal for them.
However, as in the case of CFDs, this will not be possible in Europe where the margin will go from 30 to 10: 1 depending on the liquidity of the pair.
This case was the biggest setback for the European trading industry, because it meant a drastic reduction from what was previously offered.
Also, as I mentioned, the difference with foreign brokers is huge.
Many international brokers offer leverage of 200: 1 and more.
This is why, despite the restrictions, some European traders try to open accounts with foreign brokers.
Leverage financial options
In stock options, we also use leverage to control fairly large nominal positions.
Normally and depending on the action, we can buy shares with a margin of 10% or 5% (10 or 20: 1).
For example, we have a call option for $ 44 that is trading at 2.2 for a given date.
We will be able to buy that option for $ 220 (2.2 * 100) plus the commission. That option will give us the right to buy 100 shares of XYZ for $ 44 on an X date.
As we can see, the option in that case offers us the possibility of “playing” with an investment of $ 4,400 just by having 220, with which we would have a leverage of 20 to 1.
Unlike stocks, when you buy or sell options, you already know the maximum amount of money that will be lost in the trade.
In the case of shares purchased with leverage, the loss may be greater than the initial investment.
The last major assets to reach the trading arena have been cryptocurrencies.
These assets are characterized by extreme volatility and therefore are usually offered without the possibility of leverage or margin.
In CFDs we can find 1: 1 or 2: 1.
In the exchange houses, it is normal to operate with 1: 1 but more and more brokers of this type are introducing trading with leverage of 2, 3: 1 or even more, especially in the Asian markets.
Binary options leverage
Despite the fact that these markets have almost disappeared from the world after their ban in Europe, I am going to comment on how leverage worked in a market that supposedly did not use that concept.
In binary options it is assumed that the concept of leverage does not come into play.
The structure of the operation is such that a necessary margin is not required.
The only thing necessary is the minimum investment to be able to make the bet in a certain time.
Although, anyway, let’s see an example to get an idea of the approximate leverage we use when we trade using binary options.
Suppose we make a bet that the GBPUSD is going to rise in the next 60 seconds and bet € 20.
If we lose we will lose € 20, that is, 100% of our investment, and if we win, we receive a payment from the broker that will go from 70 to 95%, that is, from € 14 to € 19.
The important thing to determine the approximate leverage (as this will always be approximate and not exact in binary), we must know what is the average volatility of that pair in the period of one minute.
Suppose the volatility per minute for that pair is over 4 pips in the last week.
If the price of that pair is above 1.5000, we will normally have the price move 0.0265% (4/15000) on average.
So, for a movement of 0.0265% we have the possibility of losing 100% of our account.
That is, basically, binary operations at 60 seconds, may well be offering us a leverage of more than 3,000 to 1. In some cases more and in others less.
With this example, we have been able to see the leverage power of binary options .
Conclusion and Review on leverage
As we have seen, there are several possibilities to use leverage in financial markets.
From null or moderate cases, such as stockbrokers, to extreme cases with forex or future brokers.
Leverage can be an interesting and very beneficial weapon, but it can also be very dangerous in inexperienced hands.
Despite what they make us believe the best for our pockets will always be to use little leverage.
I will briefly explain why.
If you are a novice trader or with few years of experience you should always use little leverage.
The reason is simple: if you have not yet discovered the secret to constantly winning in the markets, the best thing you could do is to risk little.
To risk a lot without having an almost foolproof system is to play with fire.
So it happens that in the end the vast majority of these traders end up bankrupt and with the accounts liquidated.
Just in case you have already found a fantastic and proven trading method for more than a year, then it would no longer be unreasonable for you to increase the leverage to take advantage of it, but always with caution, like an explorer in enemy territory.
That is the best advice I can give about it.
Generally, low leverage will be worth us in almost all circumstances.
Don’t be greedy and use trading cautiously.