The Basics of Leverage

Leverage is a vital tool for many successful traders

In this article, we will discuss how leverage is used in every day life and how leverage is used in the markets

Leverage is one of those daunting concepts to new traders, and for good reason. The typical investor trades assets, using cash which they already have. They need to have enough money in their account to pay for those assets outright. The major drawback of cash investing is that your gains are limited by what you can afford with your financial resources. Leverage is all about investing with more cash than you have on hand. This allows traders to invest with greatly more buying power. This increased buying power can lead to greatly increased returns; however, this strategy comes with exponentially higher risks. If leverage is not used properly, traders will end up losing more money than they are comfortable with. This can range anywhere from breaking even from what could have been a profitable position, to financial liquidation. In the absolute worst cases, this can lead to further debt on top of liquidation, although this is easily avoidable when using conservative leverage strategies.

Leverage in Everyday Life

Understanding how leverage is used in everyday life is the first step to understanding how leverage can be used in trading. Leveraged purchases happen all around us and are an integral part of the economy. Leverage applies to many aspects of everyday life but is most obvious in the housing and automotive markets. Furthermore, leverage plays an important role in the small business market.

The most common example of leverage in everyday life is how it is used in real estate. Specifically, how leverage is used in the housing market. It is uncommon for a perspective homeowner to buy a property with cash outright. People often take on a mortgage to purchase a property. For example, if you were to purchase a property which costs $400,000, you might put down a deposit of $40,000 and assume $360,000 in debt.

The purchase of a vehicle is often quite similar. For example, one may only have $5,000 in their budget to purchase a car. They could buy a car that costs $5,000, or they may choose to purchase a $25,000 car with leverage, in the form of a loan. In this case, the purchaser could put their $5,000 deposit down and take out a loan for $20,000, with an agreement to pay back the loan, with interest.

In both examples, leverage is used to purchase an asset. Houses and vehicles tend to lose their value over time. The fundamental difference between someone purchasing a car or home – like we used in our example – compared to a trader who is using leverage to purchase assets on the market, is that the traders who use leverage intend to purchase assets which they believe will appreciate over time.

Taking out a loan to purchase a business is another fine example of using leverage in everyday life. When an individual takes out a business loan, they are agreeing to the terms of paying the business loan back with interest, because they believe the profits from the long-term success of the business will outweigh the initial short-term debt that they have incurred. If the business turns out to be successful, then the debt which the investor has taken on will have allowed them to not only repay the loan but put them in a position where they have accumulated more initial capital than they would’ve originally had available, had they not incurred the debt in the first place.

Leverage in Trading

Luckily, for traders who know how to properly use leverage in their trading endeavors, it is much easier to place a leveraged position, than it is to qualify for a business, home, or car loan. MUCH easier. This also means it is incredibly easy for inexperienced traders to trade on leverage – essentially – taking out a loan to buy assets, which may turn around and bite them in the butt.

Forex trading markets often lend themselves to large amounts of leveraged trading. It is not uncommon to see Forex market trades being placed at 100X leverage – or even more – because of how the Forex market moves, in comparison to the stock market or cryptocurrency. As an example, if we were to place a USD/EUR trade, with a total exposure of $10,000, only one percent of that would need to be tied up in the trade; equating to $100.

In the stock market, you are usually going to see a smaller degree of leverage being placed, due to the higher volatility. In this example, we are trading a $1,000 share of Apple (AAPL) on 20X leverage. We would only need to tie up $50.00, as that is one twentieth of the price of the leveraged position.

In the first position, we have only tied up 1% of our funds, in comparison to the exposure of the trade. In the second position, we have only tied up 5% of our funds, in comparison to our potential exposure. Of course, these are obviously basic examples of how leverage works. There is still much to discuss regarding leveraged trading, however, this has hopefully answered some questions for those of you who are new to the concept of using leverage to your advantage!

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