Leverage is a key feature of derivatives trading that is attractive to traders. They are excited about the great profit it could bring overnight without a good understanding of its mechanism. So today, we will go over details of leverage for all traders’ references.
What is leverage?
The concept of leverage means using borrowed capital to increase the funding for an investment so that to increase potential profit. Just like a lever that can be used to increase the strength when lifting up the heavy weight, the leverage amplifies the potential profit. In a trading platform, this borrowing action is usually not that obvious. Traders’ orders are usually leveraged with a simple one-click setting.
Let us use an example to illustrate how leverage affects potential gains or losses. If you have $ 1,000 of an asset and no leverage, you can make a profit of $ 10 for every 1% increase in the price of the asset you invest in. On the contrary, you will lose $ 10, which is equivalent to 1% of $ 1,000. If you invest $ 1,000 with a 10x leverage, your position value will be equal to $ 10,000. 1% of 10,000 USD is equivalent to 100 USD, so if the market rises by 1%, you can make a profit of 100 USD, otherwise, you will lose 100 USD.
Different types of financial products with leverage
Contracts for difference(CFD), is currently very popular among global retail investors. The CFD is a contract between the buyer and the seller about the price difference. The contract requires the seller to pay the buyer the difference between the contract price and the settlement price of a commodity (if the difference is negative, the buyer needs to pay the seller). The transaction of the commodity is not involved in the whole process.
There are also many other leveraged products, such as options, futures and some exchange-traded funds (ETFs). Although these products are operated in different ways, they are all able to amplify profits or losses.
Disadvantages of using leverage
Although CFDs and other leveraged products can bring various benefits to traders, the potential negative consequences of using such products should also be considered:
Amplify the loss. The leverage will not only amplify profits, but also amplify losses. Since your initial fund is relatively small compared to regular transactions, you can easily forget the limit of risk. Therefore, you must consider the full value of your trade and take measures to realize risk management.
Unable to enjoy shareholders' rights. When trading with leverage, you give up the benefits that you can actually enjoy with the corresponding assets. For example, in stock market, the use of leveraged products may have an impact on receiving dividends. In crypto market, the staking coin can be used to vote. But leveraged positions cannot bring you such benefit.
Extra fees. When using leverage, you actually borrow money at the cost of margin to open a position. If you want to hold positions for a certain period of time, you are usually required to pay extra fees.
How do I minimize the risk with the leverage trading?
As mentioned, leverage multiplies losses. However, DueDEX has provided you with convenient risk management tools to help you reduce potential losses.
Key factors that regarding risk management include:
- Take Profit %
- Stop Loss %
- Quantity of order based on risk level
You can have an overview of DueDEX risk management solutions with the following link: https://duedex.zendesk.com/hc/en-us/articles/360043032834-How-to-set-up-Take-Profit-and-Stop-Loss-for-different-order-types-on-DueDEX-
For users who want to leverage the trading profits, leverage is a very practical tool. If used properly, leveraged trading will help to increase profitability and diversify the investment portfolio.
However, as mentioned above, leveraged trading may lead to a higher risk. Therefore, proper risk management strategies and tools should be used to minimize the risk.