What is leverage?
It is a trading tool that helps investors to invest more capital in their transactions and increase their potential profit or loss by receiving loans from others. The use of leverage is not only related to financial markets and in fact many companies and ordinary people use leverage when they use borrowed money to advance their activities. In general, this term is more prominent in the financial markets, especially the forex and digital currency markets.
Leverage is usually displayed as “a:b”, where “a” is the amount of the investor’s real capital and “b” is the total amount of money that can be involved in trading using leverage. For example, if a trader’s capital is $100 and the leverage is 1:10, the investor can enter a trade worth $1,000. The calculation of the profit and loss of the transaction is calculated with 1000 dollars, but the transaction will remain open until the total loss does not exceed the initial capital of the trader ($100).
What is the reason for using the leverage?
The main reason for using leverage in financial markets is to increase the amount of capital in the transaction in order to increase the profit of transactions
What are the types of leveraged transactions?
Leveraged transactions are a type of transactions in which it is possible to use leverage. “Future” accounts, “Option” accounts and “Margin” accounts are among the accounts in which leverage can be used. Note that there is no compulsion to use leverage in any of these accounts and traders can trade without leverage by choosing leverage.
To better understand how to use leverage in all types of transactions, it is better to provide a correct definition of this type of transactions first
The first type of transaction is the spot transaction, where leverage is not used. Spot transaction means paying the price of an asset instantly and receiving it at the same moment. This transaction is the simplest type of transaction that is widely used in the stock and cryptocurrency markets.
The second type of transactions is the futures transaction. A future transaction means a contract between a buyer and a seller, in which payment is made in the present, but the goods are delivered at a certain time in the future. Today, there is a type of futures contract called (Perpetual) in which not only the expiration date is not mentioned, but also the asset itself is not used for trading. In this case, the contract is closed on the purchase and sale price of a parent asset such as gold and ethereum, and based on changes in the price of the underlying asset, traders’ profits or losses are calculated.
The third type of trading is option trading, in which users trade the option to buy and sell an asset at a future time. Therefore, in this case, a contract is concluded between two people at a price much lower than the original price of the asset, during which the investor buys the option to buy or sell an asset at a future time from another investor. At the promised time, the investor can apply according to the conditions of the purchase or sale contract by paying the remaining money, or he can stop doing it altogether, in which case the initial money given for the contract will be given from the investor’s pocket.
Margin trading is the fourth type of trading that is used in both forex and crypto markets. Margin transaction is like spot and in which asset purchase is done in the present time and by paying its amount. In this type of transactions, it is possible to use leverage, and users can purchase a large amount of their desired assets by receiving a loan. Usually, the leverage in margin trading is lower than in futures trading
What are the advantages and disadvantages of the leverage?
The concept of leverage is used in almost all financial markets and this shows its practicality. The main advantage of leverage is providing the possibility of entering into a transaction with more capital. By using leverage, one can participate in transactions up to several times the initial investment amount and as a result earn more profit. Of course, this possibility is two-way, and leverage can lead to increased losses for traders.
In order to avoid the consequences of using leverage, it is necessary to use leveraged capital in a calculated way and in compliance with capital management techniques. The first point in relation to this issue is to use the lower lever. Using high levers psychologically puts users under pressure. In addition, the loss limit of transactions with high leverage is very low, and this makes the transaction loss limit to be activated and the assets involved in the transaction to be liquidated with the lowest fluctuation in the market.
The most important point in connection with leveraged transactions is to determine the volume of transactions. In spot transactions, users specify the volume of transactions for capital management in such a way that they do not lose more than 1 or 2 percent of the total capital when the loss limit is activated. It is also necessary to observe this point in leveraged transactions. The loss limit and the volume of the leveraged transaction should be such that only 1 or 2% of the total leveraged capital is lost if the loss limit is activated.
Having a strategy with a “win rate” and a high ratio of profit limit to loss limit, in the case of capital management, the trades will be profitable. Now using leverage helps the trader to expand his profit with leverage. Note that in leveraged transactions, the volume set for each transaction is specified in advance and entered into the system, but in margin transactions, leverage can be taken for the entire capital and a portion of it can be used to enter the transaction.