Leverage: A Trader’s Friend? (7)
Margin trading creates leverage, lets look at that in a lot more detail.
The Benefits of Leverage
Leverage can increase a trader’s return on their capital. Because the trader only needs to deposit part of the position, any increase in the equity element of the position will enhance the returns of the trade. In our example, the trader puts up only £50 of the notional value of a position. A £50 increase in the value of that position gives the trader a £50 profit. The return has increased from 10% to 100% by leveraging up the trade 10:1.
Leverage can increase the size of a trader’s positions. Traders can leverage small amounts of capital and hold much larger positions. A trader with £500 capital, leveraging at 10:1, can assume positions with a notional value of £5000.
The Downsides of Leverage
As well as enhancing profits it also enhances losses in equal measure – leverage is linear.
|BP examples||Initial trade||Price up 10%||Price down 10%|
|Notional position||£500||£550 (+10%)||£450 (-10%)|
|Margin/deposit||£50||£100 (+100%)||£0 (-100%)|
A margin call happens on an account wide basis. When position(s) move against a trader and they no longer hold enough of a deposit, or margin, with a broker then they will be asked to deposit more to keep the position open. If they don’t provide more money, the positions are closed by the broker to protect its exposure to bad debts.
The take away from this lesson is, new traders learning how to trade should not use too much leverage. These traders should place small trade sizes relative to their capital to avoid amplifying errors, which are inevitable. As they become more experienced traders and have more confidence in their trading returns leverage can be increased to increase them.