What is Leverage? How to Effectively Use Leverage in Trading Strategy

When your 1 USD can have the trading power equivalent to 10 USD, this is the power of leverage that everyone might be familiar with. However, leverage is actually better than that, and we can use it to benefit our investments. Leverage isn't limited to just the world of Futures, Forex, or Crypto markets as a trading multiplier. It can also be applied to various forms of investment, which we'll explore in this article.

What is Leverage?

Leverage is a financial tool that enhances investors' trading power. It allows them to use a small amount of capital to open long or short positions on higher-valued assets. The principle behind leverage is "borrowing" additional money or assets from the broker to increase the size of the investment.

This approach offers the potential for higher returns but also comes with increased risk. Leverage is typically expressed as a ratio, such as 1:100, meaning that one unit of invested capital can control 100 units of assets. For example, if you have $1,000 and use 1:100 leverage, you can trade as if you had $100,000. This amplifies both potential profits and losses.

How to Use Leverage Effectively in Trading

The main advantage of leverage is that it allows investors to control larger trading positions than their actual capital. This increases the potential for profit. Additionally, it improves capital efficiency by enabling diversification across more assets, reducing the risk of investing in a single asset.

Other benefits of Leverage

• Furthermore, we can use leverage to open hedging positions to reduce the overall risk of an investment portfolio.

• Leverage increases the opportunity to profit from small price movements. Using leverage allows you to make profits even from minor price fluctuations, which might not be worthwhile when investing with full capital.

• Moreover, leverage enables you to experiment with various real trading strategies using only a small amount of actual capital.

How Can We Trade By Using Leverage?

Currently, there are various trading platforms that allow us to use leverage for trading. Let's look at what we can trade using leverage.

• Forex (Foreign Exchange Market)

Use leverage to trade currency pairs such as EUR/USD, GBP/JPY, profiting from exchange rate fluctuations.

• Stocks

We can use leverage to trade stocks through margin accounts, borrowing money from brokers to buy more stocks than our available capital allows. This increases the potential for profit from stock price movements.

• Futures

Trade futures contracts on stock indices and commodities by putting up only a portion of the contract value as collateral. This allows trading high-value assets with less investment.

• Commodities

Use leverage to trade commodities like gold and oil without physically holding the goods, profiting from price changes.

• Stock Indices

Trade popular stock indices such as the S&P 500 and NASDAQ using leverage through CFD contracts or futures.

• Cryptocurrencies

One of the popular platforms for using leverage is trading digital currencies like Bitcoin and Ethereum through various platforms that mostly support margin trading.

Risk Management Strategies When Using Leverage

Using leverage in investing requires extreme caution, as there is a high risk of rapidly losing your investment if not managed properly. An effective risk management strategy is therefore essential. Start by assessing your own risk tolerance and determining how much loss you can withstand. Then, carefully analyze market conditions and investment trends to choose the right timing for your investment. Setting a stop-loss is another tool that helps limit potential damage by establishing a predetermined point at which to cut losses, preventing excessive losses.

How to Choose the Appropriate Leverage

Choosing the appropriate leverage is a skill that traders must develop through their own experience, determining whether x10, x25, or x125 is suitable for their trading strategy. The main point to remember is that excessively high leverage can lead to quick losses, while too low leverage might cause missed profit opportunities. Selecting the right level depends on various factors, including your capital, risk tolerance, and trading strategy. Traders should carefully consider and adjust leverage to fit their trading style, balancing profit potential and investment risk limitation. Here are 7 basic recommendations.

1. Consider experience - Beginners should start at 1:100 or lower, while experienced traders can increase leverage based on their expertise.

2. Account for capital - Lower capital should use lower leverage to reduce risk, while higher capital may allow for higher leverage.

3. Assess risk tolerance - Those with low risk tolerance should choose lower leverage, while those who can accept more risk may use higher leverage.

4. Consider trading strategy - Short-term strategies may use higher leverage, while long-term strategies should use lower leverage.

5. Test in a demo account - Try different leverage levels in a demo account, observe results, and adjust to suit your trading style.

6. Start low and gradually increase - Begin with 1:10, then slowly increase as you gain more experience.

7. Use risk management alongside - Regardless of the leverage level, always practice good risk management, using Stop Loss and Take Profit orders.

Recap : Common Mistakes Traders Make When Using Leverage

However, everyone should know and remember well that using leverage requires caution and a thorough understanding of our trading strategy before increasing the multiplier significantly. 

While it can increase profit opportunities, it can also lead to rapid losses. Don't let greed influence your investment decisions, as it can easily blow up your portfolio. I've seen this happen to many people. Before we list the mistakes traders often make when using leverage, let's recap the precautions to take before using leverage.

• Not setting a clear stop-loss, which can lead to severe losses

• Choosing a leverage ratio that exceeds their risk tolerance

• Expecting high profits without considering the increased risks

• Not understanding the impact of increased fees and costs from leverage

• Lack of knowledge about margin requirements (how much collateral is needed)

• Neglecting market analysis before leveraged trading, not giving enough importance to analyzing market trends

• Making decisions based on emotions rather than data

• Increasing trade size too quickly before testing if the strategy has a high win rate

• Failing to adjust strategies according to market conditions

• Using the same leverage without considering market volatility, not adjusting leverage levels to suit changing situations