What Is Leverage in Day Trading?
Leveraged trading, also known as margin trading, is a type of trading which is based on opening trading positions on the financial markets with the use of a small amount of capital with the possibility to take larger positions in the market.
Leveraged trading is becoming a more and more popular option for traders and investors as it allows them to increase their potential returns at a faster pace. However, it is those people with limited capital and knowledge who are usually more fascinated and intrigued by leveraged trading since they believe they’ll become much wealthier faster than practicing any other method of trading. But the truth is, this is not always the case.
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Let us tell you that if you’re truly serious about being successful in the stock market and planning to do it on a long-term basis, you should follow the main rule when it comes to the trading market: the higher the risk, the more knowledge, and experience you need to negate it. This becomes even more important when trading with leverage.
How Trading With Leverage Actually Works
Let’s review a specific example for you to better understand how stock trading with leverage works.
Trading with leverage example
If you have $1,000 in your trading account and the ability to trade with 1:5 leverage, instead of managing your positions for a total amount of $1,000 you get the opportunity to open positions for a total of $5,000. This means that if you open a $100 position with 1:5 leverage and a 1:2 risk-reward ratio instead of risking $100 and having the ability to earn $200 you risk losing $500 and get the ability to earn $1,000.
As you can tell, this form of trading is highly risky if you have no idea how it works. With the use of leverage, you not only get the chance to earn more, but you also risk blowing your account much faster than without leveraged trading.
This is why some experts don’t recommend trading leveraged accounts to novices and instead suggest sticking to regular trading. However, there are also some trading experts that don’t agree with this. They suggest that with proper day trading education and a serious approach trading with leverage can be just as safe as trading without it.
As with most things in life, trading with leverage clearly has it’s advantages and disadvantages. Let’s discuss them a bit more to better understand whether day trading with leverage is actually a good choice for you or not.
Pros of Trading with Leverage
Magnified Profits
The first and top reason why many people use leverage is due to the chance to get amplified profits. You invest your money and then multiply that by your leverage. So, if you make money on this trade, you make a huge amount! If you compare how much money you can make day trading without leverage, you might get a strong urge to stick to leverage.
Access to More Expensive Stocks
Sometimes when you have a small account and no option to use leverage you can miss out on some great trading opportunities. Often the price of a single stock of some company can be larger than the size of your whole account. If you see some great opportunities to enter a trade, but not enough account size leverage can help you out tremendously.
Diversification of your portfolio
Leveraged trading truly opens many doors that would otherwise be closed for day traders. Having the ability to operate much larger amounts of money allows entering much more trades and diversifying your portfolio. It is commonly agreed by most experts that having a versatile portfolio is very beneficial to any day trader or investor.
Cons of Trading with Leverage
Magnified Losses
Magnified profits come hand in hand with magnified losses. Just like everything in the stock market, this is always a two-way street. If you’re not considering loss potential, then it means you have no solid trading plan or a well thought out strategy. Trading with leverage certainly exposes you to the risk of losing all your money much faster and thus can be the main factor of ending someone’s trading career.
No Direct Ownership of the Assets
Trading with leverage means that at any point in time of your trades you don’t actually own the assets that you are trading. Instead, people that trade with leverage usually follow a CFD model with their broker. While this is not a crucial disadvantage because you still receive all the money that you get from your winning trades, some people dislike the fact of not actually owning the assets that they trade.
More Trading Commissions
While this can differ from one broker to another, it is commonly accepted that trading with leverage involves slightly higher commissions. Trading fees are considered to be one of the main factors that end trading careers. Often the difference between a green and a red trading day is trading commissions, so having higher ones in leveraged trading can definitely become a problem.
Conclusion
Most trading experts agree that leverage comes with high risk as it magnifies the possible profits or losses. This belief is derived from the premise that a much safer way of trading is when a person cannot lose more money than he or she has on their account. Trading with leverage removes these restrictions and traders are open to amazing profitable opportunities and to much larger risks than usual.
However, having all the disadvantages and risks in mind, day trading with leverage can be amazing for many traders. All you have to do is invest your time and energy into proper day trading education. As soon as you become a great trading specialist, leveraged trading brings you much more benefits than risks. You only need to obtain confidence in your trading skills and get ready to manage much larger trading positions that you normally could without leverage.
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