Trading on leverage can be a powerful tool for maximizing potential profits in the financial markets. Leverage allows traders to control a larger position with a smaller amount of capital, amplifying both gains and losses. As a direct result of this, leverage can offer significant opportunities, but comes with inherent risks. Therefore, it is important for traders to approach leveraged trading with caution and follow some useful tips to increase their chances of success. A general principle traders should follow – only trade what you can afford – applies to leverage too, and requires the calculation of maximum potential losses. Needless to say, classic risk management tools such as stop losses are essential.
Basic principles
Before engaging in leveraged trading, it is crucial to fully comprehend the risks involved. Leverage magnifies both profits and losses, meaning that a small adverse market move can lead to substantial losses. Traders should only use leverage with funds they can afford to lose and have a comprehensive risk management plan in place, including an appropriate method for measuring risk. Proper risk assessment and management are essential to protect capital and maintain a sustainable trading strategy.
One of the key points to understand is that leverage increases returns by increasing risk: the financial markets, whether based on insurance, loans, or tradable securities, involve paying premiums for taking on risk. The greater the risk, the greater the premium, but also the greater any potential losses. Unless you find one of the vanishingly rare opportunities for risk-free arbitrage, this rule holds fast in all situations. The increased returns leverage offers are increased premiums for taking on more risk.
Leveraged trading strategies
A well-defined trading strategy is vital for any trader, but it becomes even more important when trading on leverage. Since leverage amplifies the impact of market volatility, it is even essential to have a clear plan in place, a plan that you must not deviate from by exiting trades inappropriately or by losing control to your emotions. Define your entry and exit points, risk tolerance, profit targets, and position sizing rules, and commit fully to following them. Stick to your strategy and avoid impulsive trading decisions driven by emotions or short-term market fluctuations. Good traders are strategic, rather than reactive.
Risk management and leverage
Leverage amplifies the impact of volatility, and increases the amplitude of both gains and losses. Unsurprisingly, this makes implementing effective risk management techniques essential when trading on leverage. From basic strategies, such as setting your maximum acceptable loss per trade and using appropriate stop-loss orders, to complex risk measurement techniques, there are a range of techniques to improve outcomes in leveraged trading. The most obvious is to avoid overleverage. Your account will likely have a leverage maximum, but this is probably considerably in excess of a reasonable limit, except for the best-funded traders. Over-leveraging increases the risk of margin calls and other adverse events. Because leverage magnifies volatility, standard practice such as portfolio diversification, or even hedging using derivatives, is even more important.
Position sizing
When opening a leveraged position, it is advisable to use a somewhat smaller trade size than you normally would. This allows you to adjust for the increased volatility of leveraged positions, and helps protect you in case of market volatility. Particularly for newcomers to leveraged dealing, this approach allows you to gain experience and confidence without risking a significant portion of your capital. Gradually increase your position sizes as you become more comfortable and consistently profitable. Patience and discipline are key traits for successful leveraged trading.
Margin maintenance
Above all, leveraged traders must closely monitor their margin requirements. Leveraged trading involves maintaining a sufficient margin to support your positions, and a failure to maintain this margin – which can occur through unrealised losses – will often result in a margin call. Keep a close eye on margin requirements, as they can change based on market conditions, asset volatility, and regulatory policies. Margin calls, unless you have a significant volume of cash to hand, will result in a forced liquidation of positions, leading to significant losses. Stay vigilant and ensure you have enough margin to sustain your trades.
Acceptable loss levels
One important point to remember is that your maximum acceptable loss, and accordingly the risk / reward ratio, must be changed during leveraged trading. Leverage of ten to one will increase a 1% price move to 10% (actually slightly less because of the cost of borrowing the money, but for these purposes we will use 10:1 exactly), working in both directions. That means if you want to maintain a max drawdown of 10% on your portfolio, you must not exceed 1% losses on any position with 10:1 leverage. This may seem obvious enough but requires re-working of stop loss placements to manage properly.
Psychological factors
Because leveraged trading enhances both risk and reward, it can increase stress amongst traders. This is a little-considered but major part of risk management practice. Given most of the mistakes in managing risk, at least when not dealing with complex derivatives such as options, involve ‘obvious’ errors, it is normally stress that causes them. When we are anxious or nervous, good habits fall away and we start to trade reactively, making frequent errors and not paying attention to essential market practice. Controlling your mindset involves taking care of yourself while trading, not getting overly attached to single trades, and maintaining a proper record of your moods and market activity in a trading journal. This helps protect against the unforced errors stress produces.
Conclusion
An overly strong focus on the dangers of leverage mustn’t blind traders to its positive side; leverage enhances returns, makes trading effective for those who control less capital, and allows us to control larger positions than we could otherwise afford. All of these are great positives to the use of leverage, and its ubiquity in retail trading is a sign of its strength. However it is important not to be naïve about trading on borrowed money: leverage can cause significant problems for the unprepared. Being as aware as possible about all the potential risks – including those linked to market psychology – and taking necessary risk management steps to prevent them, can enhance your use of leverage considerably. One important part is financial education: when we enter a leveraged trade, it is even more important to understand our rationale and trading strategy thoroughly.
How Rakuten can help
Leverage magnifies gains and losses by expanding the risk profile of your trades. The use of margin has improved the returns of many traders, but can lead to ruin if entered into without proper planning. A great way to practice using margin in a risk free environment is with a paper trading account, so why not open a free demo account today?