What Is Leveraged Trading?
Leveraged trading is trading with borrowed capital. Borrowed capital is any capital that is not equity capital — capital that the financial institution or investor already owns. In the case of most lay investors, this capital will be cash.
It will most likely be the money the investor has deposited into the investment account of their choice. It is the money that the lay investor has at their immediate disposal to put into trading.
This means that borrowed capital is essentially correlated to the debt the investor must take on to make the trade. There are many ways to take on this debt. For example, you can acquire borrowed capital by taking out a loan or using credit cards.
The essential factor about leveraged trading is that it provides leverage.
That is, leveraged trading allows the investor to spend less capital to make a potentially significant profit in the future. In this, there is “leverage” between the amount of capital initially expended and the capital potentially earned in the future.
Many investors use leverage to maximize potential returns; however, it includes a lot of risk management to ensure volatility and high-risk market conditions don’t hurt you in the long run.
Margin Trading
One example of leverage trading is margin trading. It is perhaps the simplest of the leverage trading options available.
Margin trading is a common way to use borrowed capital to trade in the stock market. Margin trading is facilitated by the brokerage or the trading platform and is a form of a loan.
It’s a loan immediately administered by the brokerage so that you can multiply your total investment in mere seconds with the click of a button. It allows the investor to trade multiples of their deposited capital so that the investor can make a more significant profit when the opportunity strikes.
This potential to make much money without having the cash at hand makes margin trading especially attractive. Even though you may only have very little liquid money, you may be able to invest multiple folds of the cash you have at hand.
For example, instead of being limited to merely investing $1,000 on an investment that the trader is confident in if the margin is one percent, margin trading allows the investor to trade an additional $100,000 by taking out a loan directly from the brokerage.
With such a significant increase in the available capital and its ease of use for those who have the option at their brokerage, it makes sense that this high-leverage trading option is so popular.
It can be a great option if an investor is confident in how the market moves and feels secure in their long positions. If the stock moves up two percent, in the example we used above, the investor makes not $2 but $200 off their investment. That is a 10,000% increase in the total profit they can drive.
Of course, as with any loan, debt incurred from margin trading will have an interest attached. Whether or not you profit, you will have to pay off your loans and margin calls. This has to be considered when deciding to trade on the margin.
Options Trading
Another way to trade with leverage is by options. Options are simply contracts you can buy that give you the right to buy or sell a particular asset at a given time. Most often, you do not need the funds to fill those contracts you buy, so it is a leveraged investment.
Although this is not explicitly borrowing capital through a loan, you are trading a contract for the bets on the capital you might have in the future.
You are spending money on the premium to buy the option, which is a price you have to pay whether or not you decide to execute the contract and whether or not you make a profit.
If the initial cost of margin trading was the interest, in options trading, the initial cost is the more significant cost of the premium, the contract’s price. However, in the case of the option, the future risk may be far less than the initial risk as options do not need to be exercised.
Futures Trading
Yet another option for leverage trading is futures contracts. Every similar concept to options trading applies here.
However, the risk is amplified because of the binding nature of the futures contracts. You must fill in the contract’s terms if you buy a futures contract and then either buy or sell the amount of the assets you have confirmed to execute in trade.
Leveraged ETFs
Building on the traditional exchange-traded funds (ETF), the leveraged ETF is essentially an ETF that multiplies the movement of the ETF by a predetermined multiple.
So, for example, in the traditional ETF, if the underlying assets of your ETF move up by one percent, your ETF’s value would increase by one percent.
However, in the leveraged ETF, if the leverage ratio for the leveraged ETF that you purchase is 3:1, when the assets underlying your ETF move up by one percent, the ETF’s value will move up by three percent.
As you can imagine, your profits would be immense compared to your initial investment. However, the losses would also be equivalently massive.
For example, let’s say that you invested $1,000 in a leveraged ETF. Now, if the underlying assets of your ETF went up by an extraordinary 35%, the profit from this movement for you would be $1,050.
However, on the contrary, if the underlying assets had gone down by 35%, your losses would be $1,050. In the end, you could have $2,050 or minus $50.
Because you were indirectly working off the money you never had, you could end up with debt rather than a payment.
Leveraged Trading in Foreign Exchange
It’s worth mentioning the prevalence of leveraged trading in foreign exchange. There is widespread usage of margin trading in the foreign exchange market precisely because the fluctuations in currency prices tend to be relatively small.
For this reason, it’s not uncommon for foreign exchanges to offer margins as low as one percent. While not as trendy as maximum leverage margin trading, exchanging USD for other currencies is a great way to get in on leveraged trading.
Risks of Leveraged Trading
As you can see, the risks involved in trading with leverage can be rather severe. This is why it is always important to calculate the risks involved before participating in leveraged trades.
Depending on your position size, you may need substantial capital to stop loss and break even if things go south.
Leveraged Trading in Crypto
Finally, we can discuss leveraged trading with cryptocurrencies like Bitcoin (BTC) and Ethereum (ETH).
As usual, much of what happens in the traditional investment world has parallels in the blockchain and in the cryptocurrency market.
We can talk about three types of leveraged trading work we discussed above in general for the crypto market: margin trading, options and futures, and leveraged ETFs.
Crypto Margin Trading
The same thing in traditional margin trading can happen in the Web 3.0 world when investors trade crypto. Many brokerages offer a margin for your trading strategy such that, depending on the amount of money you deposit into your trading account, you can trade a certain multiple of that deposited cash.
The actual margin you will be able to trade with depends mainly upon the trading platform or brokerage you are using, but some platforms will allow you to trade as much as five times your current funds.
Crypto Options and Futures
Crypto options and crypto futures are very similar to traditional options and futures. In the same way that conventional options and futures work, crypto options and futures allow you to buy contracts that you can execute later.
The difference between the options and futures in crypto is the same as that between traditional options and futures: futures are obligatory, whereas options are optional to execute.
However, one great benefit or opportunity seen in crypto trading is that the buying and selling of crypto options and futures are 24/7.
Unlike the traditional options and futures tied to the exchange’s open and close times, you can trade options and futures on a crypto exchange like Binance. This is because crypto exists on the web (Web 3.0, in particular). The online nature of crypto allows you to set your contracts to a specific time and date much more flexibly than traditional options and futures.
Crypto Leveraged ETFs
A relatively new development is still in the formation stages. Still, a leveraged ETF based on crypto assets works the same as any other ETF based on more traditional investments like stocks.
For example, in a crypto-leveraged ETF, if the underlying crypto derivative or set of cryptocurrencies were to increase in value by one percent, the ETF itself would increase by three percent (assuming a three-times leveraged ETF).
In an opposite scenario with the same terms, if the underlying crypto decreased in value by one percent, the value of the ETF would fall at a rate of three percent.
Final Thoughts
Leveraged trading on cryptocurrency exchanges could be an excellent option for those who are willing to take a little bit more risk and try to raise their profits.
However, you must understand leveraged trading to comprehend the nature of the investment. Whether it is simply taking on a bit of debt by margin trading or by taking on a risk of buying contracts for the future that you might lose money on, you are essentially betting with money you do not have at the moment.
Whereas in regular equity capital trading, you may only lose as much money as you have at the moment, in leveraged trading, you may likely lose more money than you have. You can quickly end up in the negative.
This is why being informed of the market and the instruments used is a crucial detail you must keep in mind as a trader.
Especially in the case of leveraged trading, the difference between a huge profit and a large loss could be a matter of a fraction of a percent.
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Sources:
What Is Financial Leverage, and Why Is It Important? | Investopedia
Capital: Definition, How It’s Used, Structure, and Types in Business | Investopedia
Margin Trading: What It Is and What To Know | NerdWallet
What Is an Exchange Traded Fund (ETF)? | Investopedia
Leveraged ETFs: The Potential for Bigger Gains—and Bigger Losses | Investopedia
Leveraged Investing Strategies – Know the Risks Before Using These Advanced Investment Tools | SEC
Forex Leverage: A Double-Edged Sword | Investopedia
