Saturday, 4 April 2015

Leverage is a Double Edge Sword!

Leverage is a Double Edge Sword!

Leverage can assist in making a trade very profitable or make a huge loss if it goes another way. So what is leverage?

Essentially, you are borrowing money to magnify your trade. So if you are right, your gains will be magnified. If the trade goes the other way, your losses will be magnified as well. Let's say you have a leverage of 50x from your broker, you are controlling $100,000 worth of assets with only $2,000 capital. Sounds pretty good right? Only if you are right!

A 2% increase on $100,000 will result in $2,000 profits. That would be a 100% increase on your initial capital. On the other hand, a 2% drop of $100,000 will result in a $2,000 loss. This means your initial capital of $2,000 will be lost and you would need to start with a new account. If you lose more than 2%, then you will owe the broker. In a sense, you are now officially negative or in debt. Most brokers will not let it get to this stage and will either give you a margin call when you do not meet their minimum margin, or automatically close your positions so they do not get affected by your mistakes. 

A good example recently would be the Swiss Franc Crisis where the brokers who were seriously affected had to close down because their customers were highly leveraged on the losing position. When the support fell, their stop loss were not triggered as the prices were very far out. Hence, they made huge losses that were unrecoverable. 

If you choose to invest in a financial instrument that is leveraged, you need to know how it will affect your trades and accounts. Just because you set a stop loss does not mean that you will be safe. If the price drops rapidly, the stop loss will only be triggered at the next best price and not at the price you initially set. Hence you could lose more than you bargained for. 

Below is a table indicating how much leverage and the percentage of a move to double or wipe out the initial capital.

% to double or wipe out account
X 1
X 2
X 5
X 10
X 25
X 50
X 100

In short, leverage is a double edged sword. The bigger the leverage, the easier it is to earn or lose it. Hence it should only be used if you truly understand the financial instrument and the risk involved.

Investing Wolf
Disclaimer: This is not a recommendation to buy or sell any mentioned stocks or securities in this blog.

1 comment:

  1. I am currently trading with leverage. Great article!

    Oh by the way, I've updated my site to!