What is leverage and leverage ratio?
Leverage is the trade of any financial asset with capital that doesn’t yet belong to the trader. This means that the purchasing or selling power of the trader’s capital investment increases and it allows the investor to trade with more money than the amount actually invested.
The ratio of leverage indicates the carrying power of the initial capital invested. For example, Rs. 100 invested with a 10x leverage has a purchasing power of Rs. 1000.
Significance of Leverage
Leverage is a financing tool that allows for better capital efficiency as traders do not have to lock up entire amounts of capital in the markets. They inject liquidity into the market by allowing the investors to buy without having to invest huge sums of money initially. As the use of leverage increases potential returns, an investor can make a good chunk of return on his investment while opting for higher leverage.
The effects of opting for higher leverage
Many first-time, or even experienced traders make the mistake of over-using leverage. It then becomes a high-risk activity, where even the slightest fluctuations in the market can result in significant losses to the investor in the market.
Although there is no rule set in stone about a certain method of trading, errors on the part of the trader that can easily be avoided have to be identified. The above holds in the case of highly volatile investment avenues, such as commodities. In the case of cryptocurrencies, the very nature of the market being unpredictable can significantly increase the chances of incurring a heavy loss, sometimes even outriding the principal amount invested initially.
Here is an illustrative example of a well-leveraged portfolio:
An investor lacking enough funds to invest in financial markets chooses to switch between markets. In other words, it shifts its position from the bond & stock market into the futures & options (F&O) market. The capital required to take a position in derivative markets is significantly lesser than the capital required to take a position in bond & stock markets.
It is considered wise for an investor to leverage his position as a fraction of the price required to buy on margins rather than trading directly. They hence carry greater potential for being profitable and can provide greater returns if the market performs exceedingly well.
Let’s understand the same with the help of an example below to demonstrate the increased returns that future contracts provide vis-à-vis normal equity trades:-
The impact of transaction costs on leverage
Along with carrying a greater risk of incurring losses, leverages also run the risk of increasing the allied transaction costs. Irrespective of the market’s movement, whether positive or negative; we still have to incur transaction costs in the form of brokerage or also recurring costs while trading perpetual contracts.
There is a direct relationship between leverages and transaction costs – amounting to higher risk. Furthermore, if the trade margins are considerably smaller, the expenses sometimes can appear significantly larger than the potential gains that can be made.
How do expert traders significantly manage balancing leverages?
An optimum level of leverage is recommended while trading as being conservative in derivatives trading is usually advisable, especially in the case of larger volumes. Stop orders to reduce downsize of capital and setting smaller upper limits for each position taken are advisable. The amount of leverage used depends on the trader's expertise, appetite for risk, and willingness to trade at higher volatility.
Professional traders usually have an appetite for greater risk, but it is considered wiser for them to not increase leverage beyond a certain specified limit. For example, an investor might not want to take leverage more than beyond a certain level, say 8-10 percent. For sustainable growth and achieving realistic targets, lesser amounts of leverage are preferred by expert investors who peg their leverages at around 5 percent or so.
Trading with significantly higher volumes of leverage can be increasingly dangerous for even the most experienced investor since it may also negatively affect the return on the original investment. Greater potential losses combined with higher transaction costs can harm the overall investment. That’s why professional investors with higher trade volumes limit their leverage amount to not more than 10x of the total in derivatives.
What are the other ways in which leverage risk can be minimized?
An investor shall regularly book profits on his total investment to minimize the total risk exposure and also time his investments according to the market’s trends. Strategic analysis and a deep fundamental study of the technical aspects of the trade shall be useful in understanding the significant risks involved. Reinvestment of profits from time to time shall also help speeden the growth of the overall investment.
An initial deposit has to be made before money can be borrowed for taking leverage. The amount of leverage taken and the total number of open transactions will decide the deposit margin required. Every trader has to provide a margin for every leveraged trade apart from the first investment. More money needs to be added to the trading account if the market goes against the position held by the trader.
Conclusion – The Final Word
Derivatives are an outstanding and effective financial tool to multiply one’s income, and trading using derivatives does bring amazing returns on a trader’s investment. On the contrary, it is also quite risky and requires greater expertise on the part of the trader. Combine it with cryptocurrencies, and trading crypto could get all the riskier.
A trader may initially begin by investing less money and test the waters for greater returns by the use of leverage. However, using significant leverage might quickly result in liquidation due to the inverse relationship between leverage and market volatility. Lower leverage applied to trades gives more leeway by allowing the trader to set broader but diligent pit-stops and avoid running a higher principal loss in the event of a downfall.
It may be noted that every trader's needs can be addressed by changing the leverage percentage at any given point in time. One needs to take due care when trading and consider individual risk tolerance before using leverage. The bottom line is - never use leverage when trading with money you cannot afford to lose.
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