Leverage Trading
Last updated
Last updated
Leverage can be understood in two ways. First, it simply acts as a multiplier for your position size, allowing you to hold a $5,000 position with only $500. At first glance, leverage may seem like a ticket to unlimited wealth, luxury yachts, and Lamborghinis.
While it may seem like free money, there's more to it than meets the eye. Leverage allows you to increase your position size by borrowing from the platform, leading to magnified profits and losses.
Suppose you have a $10,000 position with $1,000 in equity (often called margin). In this case, the position has 10x leverage, meaning the position is 10 times larger than the margin. Since profits are generated based on the entire position size, a 1% move in the position results in a $100 gain, which is 10% of your equity or margin.
This allows you to make significant profits, but only if used correctly. Conversely, a 10% drop can cause you to lose the entire position; when your losses on the position size exceed your margin, the position gets liquidated.
Returning to the simple explanation, if you use leverage without proper risk management, it indeed amplifies your position size, but the percentage of moves as well. This exposes you to the risk of being forced to sell (liquidation). In spot trading, this risk doesn't exist, but you're limited to your capital alone.
So, which option is better? As with many aspects of trading, it depends on both the situation and the trader. Leverage can be fantastic when used with proper risk management. By implementing a suitable stop loss, you can eliminate the liquidation risk and set a limit on the maximum amount you can lose. However, you still reap the benefits of leverage: increased position size and profit potential.
In essence, leverage can be an excellent tool to add to your portfolio, but only after you've demonstrated a solid understanding of risk management and have some experience in spot trading. If used by inexperienced traders, leverage can wipe out your entire portfolio in just minutes.
Risk management is essential when dealing with leverage. To use an analogy, leverage is like a nuclear power plant – extremely powerful and perfectly safe if you keep it in check. However, if you don't pay attention to what you're doing, the consequences can be disastrous. If you have a solid plan, stick to it, and manage your risks!
