When you learn how to trade in stocks, one of the first questions that often comes up is “How much leverage should I use?” Using leverage when you first learn to trade can be very dangerous, even though it is heavily promoted by CFD and Forex providers out in the market.
Why using too much leverage can be dangerous is best explained through an example. If you were to experience a market crash and you were highly leveraged and 200% long…this would likely wipe out your account and take you out of the trading game.
Firstly, an explanation of the key terms.
Leverage: means you are borrowing money to trade e.g. you have $100 and you borrow another $100 (using your original $100 as collateral for the loan) and you buy $200 worth of shares. This is using borrowed money to gain higher exposure to the market.
Trading Long: means you make money when the price of the instrument goes up i.e. you buy it first, and then aim to sell it later at a price higher than what you paid.
Trading Short: means you make money when the price of the instrument goes down i.e. you sell it first and then buy it back later at a lower price than what you sold it for. (In the stock market you achieve this by first borrowing the stock through your broker, selling it and then waiting for the price to fall before buying it back and returning the stock to its original owner.)
Back to the example, if you are 200% long (you have $200 exposure on the long side for every $100 in equity you have), and you have $50,000 of your own money in your trading account, this means that you have borrowed an additional $50,000 to invest a total of $100,000.
Now if the market crashes and the next morning the entire market opens 50% lower than where it closed the day before (a very extreme event) – because you have $100,000 invested, the value drops by 50% to $50,000.
How much equity are you left with? The answer is ZERO because whilst you have $50,000 left invested, you still owe $50,000 that you borrowed, so once you pay off the loan you are left with nothing!
Conclusion On LEVERAGE:
Leverage is a double edged sword – it can help you make more money, but it can also cause you to lose much more money if you are not careful with it.
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