Leverage: Meaning and how to use it [Guide]

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Published: December 15, 2020 by Andrew

Financial Leverage allows you to use less capital than is necessary for the investment you are making. The advantages of this tool are obvious, you can get high returns even with small investments, but how is it used?

Leverage is used in this way:

  • You select the multiplication factor (the Leverage) in the online Broker platform
  • Sufficient margin is maintained to cause prices to fluctuate
  • The return will be proportionate to the leverage used

In this guide we will explain in detail how to exploit the advantages of Leverage and limit its disadvantages. To start you will have to choose a serious and reliable CFD Broker such as those indicated below, among which we also find eToro, the market leader.

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    Leverage: what is it?

    Leverage is the use of borrowed money (in debt) to finance the purchase of assets with the expectation that the income or capital gain of the new asset will exceed the cost of the loan.

    Usually, those who offer financial leverage put a limit on the risk they are ready to take and will indicate a limit on the amount of leverage allowed.

    Let’s take a real example to better understand how it works:

    Let’s say you want to acquire an asset that costs $ 100,000. You can use your own equity or a loan.

    If you opt for the first option, you will become the owner of 100% of the asset and will not pay interest. If the asset price goes up to 30%, the asset’s value will increase to $ 130,000 and you will make a profit of $ 30,000. Similarly, if the asset depreciates by 30%, the value of the asset will become $ 70,000 and you will suffer a loss of $ 30,000.

    If you opt for the second option, you can finance the asset with 50% shares and 50% debt. If the asset appreciates by 30%, it will be valued at $ 130,000. It means that when you pay off the $ 50,000 debt, you will have $ 80,000 left over, which translates into a profit of $ 30,000. Similarly, if the asset depreciates by 30%, the asset will be valued at $ 70,000. This means that after paying off the $ 50,000 debt, you will be left with $ 20,000 which translates into a loss of $ 30,000 ($ 50,000 – $ 20,000).

    In this example we have not counted the possible interest that a creditor will make you pay to lend you the money and which obviously affects the performance of the transaction.

    Leverage in Trading

    After seeing the concept of Leverage, let’s see how this applies to online trading.

    Traders usually do not have all the capital necessary to carry out “cash” operations but use financial leverage, that is, they borrow money for operations, so as to increase their purchasing power.

    In trading, leverage is exploited by investing a small percentage of the total amount necessary for the trading operation, the rest is covered by the leverage effect.

    For example, if you want to invest in a $ 10,000 trading operation, a leverage of 10:1 allows you to use $ 1,000 only.

    The financial leverage is directly linked to the margin, which is the minimum amount of money you must have in the account in order to use a certain leverage.

    How to use Leverage

    Leverage allows you to invest more money than you actually have, the rest is “lent” by the broker you are using.

    The best way to trade with Leverage is to use CFD Brokers, intermediaries that allow you to trade in Stocks,Indices, Cryptocurrencies, Forex, etc.

    CFDs are Contracts for Difference that allow you to invest up or down on numerous assets.

    These financial derivatives (CFDs) as well as allowing you to Sell on the Overdraft (aiming down) have a very convenient feature, they allow you to trade without commissions.

    But how does the financial leverage work? Here are the steps to follow to trade with Leverage:

    • Register on a CFD Broker
    • Choose the security you want to trade on the demo or real account
    • Decide whether to buy or sell, set the amount you want to invest in the operation
    • Select the leverage, which can range from 1X to 30X and set a stop loss to determine the maximum risk

    Depending on the leverage chosen and the stop loss, you will need a sufficient operating margin, that is, a balance on the account that allows you to keep the transaction open.

    Be careful, leverage must be used with great caution!

    Read More: Stop Loss.

    Where to use Leverage

    The choice of the Broker to use for trading on leverage is essential, you must rely only on safe and reliable intermediaries, such as those we have indicated at the beginning of our guide.

    The European Authority for Financial Instruments and Markets (ESMA) has set precise limits on financial leverage and all regulated brokers operating within the European Union are required to comply with them.

    Here are the financial leverage limits imposed by ESMA in March 2018:

    • 30: 1 for major currency pairs (such as EUR / USD)
    • 20: 1 for secondary currency pairs (such as EUR / NZD), Gold and major indices
    • 10: 1 for Commodities other than Gold and minor equity indices
    • 5: 1 for CFDs in stocks and ETFs
    • 2: 1 for Cryptocurrencies

    To help you choose the Broker to use for your investments with Leverage, below you will find brief reviews of the 3 online Brokers that we believe are the most suitable for trading with Leverage: eToro, ForexTB and Trade.com.

    eToro

    Our first choice regarding CFD Brokers to trade with Leverage fell on the market leader, the most widely used and used Broker in the world.

    eToro has achieved truly incredible popularity, convincing over 10 million users around the world and relying on the licenses issued by the most prestigious control bodies such as CONSOB and CySec.

    How to use leverage with eToro? Here are the steps to follow:

    • Register for free on eToro
    • Log into your Demo or Real account (making a minimum deposit of € 200)
    • Select the CFD of the stock you want to trade and choose the leverage
    • Decide whether to buy or sell and how much to bet in the operation
    Try the eToro platform for free

    If you prefer automated investments, eToro allows you to copy the market operations of the best eToro traders, automatically and for free.

    This tool is called Copy Trading and it allows you to get the same returns as very experienced traders, without doing practically anything.

    Here are some examples of traders you could copy on eToro:

    etoro-copytrading-famous traders

    Click here and choose which traders to copy

    Before making real investments you can practice leverage and copy trading in demo, without running any risk. You can test the trading platform with virtual money and then switch to the real account by depositing at least € 200.

    Click here to sign up for free on eToro

    ForexTB

    Trading using leverage requires some experience and good knowledge of the markets and online trading.

    ForexTB has decided to improve the preparation of its traders by offering a very complete trading course full of practical examples for free.

    This ebook is the most downloaded basic trading course in the world and it is totally free, here is the link to download it now:

    Click here and download the Trading Course for free

    The security of this Broker is guaranteed by CySEC and to offer more choice options to subscribers, ForexTB offers 2 very different trading platforms but both suitable for trading with Leverage:

    • Metatrader 4, a very professional software suitable for the most demanding investors.
    • The Web Platform, a very intuitive, fast and accessible software from the web, without downloading or installing anything.
    Choose your trading platform by clicking here

    How to use leverage with ForexTB? Follow these 3 simple steps:

    1. Register for free on ForexTB and log into your demo or real account (making a minimum deposit of € 250)
    2. Select the CFD of the stock you want to trade and choose the leverage
    3. Decide whether to buy or sell and how much to bet in the operation
    Click here and register for free on ForexTB

    Trade.com

    Leverage allows you to increase the size of your investments from much smaller amounts and Trade.com has made these figures even lower.

    Trade.com is a very famous Broker, especially for the minimum deposit threshold it has established: 100 €.

    This figure is much lower than the market average and allows you to do real trading even with very low capital.

    The security of this Broker is certified by CONSOB.

    How to use leverage with Trade.com? Here are what steps you need to follow:

    • Register for free on Trade.com
    • Log into your Demo or Real account (making a minimum deposit of € 100)
    • Select the CFD of the stock you want to trade and choose the leverage
    • Decide whether to buy or sell and how much to bet in the operation
    Click here and register for free on Trade.com

    To find out how to make the most of financial leverage and learn the most profitable trading strategies, we recommend that you download the Trading Course developed by Trade.com for free.

    It is a pdf that contains the basics of technical analysis and the techniques most used by professionals, and it is also totally free!

    Download the Trading Course for free by clicking here

    Leverage: limit the risks

    Leverage is an exceptional tool, which if used well allows you to obtain high returns even by making small investments.

    As we have said several times throughout this guide, it also has a downside, in fact it exposes you to a greater risk of losing the capital available for trading.

    To limit the risks it is necessary to carefully follow these 5 basic rules:

    1. Carefully evaluate the average fluctuations of the stock that interests us.
    2. Prices must be able to move freely, without the “Margin Call” immediately intervening.
    3. Always set a Stop Loss when opening an operation.
    4. Don’t open a position if you don’t have enough margin on your account.
    5. Better to open a smaller position and have more margin.

    These are just some of the basic rules to make the most of financial leverage without getting into trouble. You will find many other suggestions in the trading courses that we have proposed and that you can download for free from these links:

    Risk Warnings for Leveraged Trading

    Online brokers are required by law to declare what risks are involved in trading online, what percentage of users are at a loss on average and not to abuse financial leverage.

    Warnings are a must but they serve more than anything else to make novice traders aware that they must not exceed with financial investments, especially with high leverage.

    In fact, despite the fact that it allows you to earn a lot thanks to its multiplication factor, when the trend goes against us, it can lead us to lose a lot of money with equal ease.

    Margin

    By using Leverage to trade CFDs, you will need to maintain a certain level of funds in your account (the necessary margin). Margin requirements vary by stock and market and are clearly stated by every online broker.

    Understanding the margin levels will help you not to exceed the investment. A sudden price movement against your forecast could wipe out your margin and lead to the automatic closing of the operation due to insufficient funds in the account.

    The so called “Margin Call” or Margin Call is a warning that the margin is dangerously thinning and if no other sources are deposited, an automatic closing of the position could occur.

    The automatic closing is necessary to prevent traders from losing more than the money they have in their account and thus go into debt with the Broker.

    Limits on financial leverage imposed by ESMA

    The European Financial Instruments and Markets Authority (ESMA) has agreed on a set of rules to limit CFDs and permanently block binary options.

    These limits were imposed because the analyzes carried out showed that 74-89% of trading accounts generally lose money, with average losses per trader ranging from € 1,600 to € 29,000.

    Binary stocks had even greater loss rates and this caused a lot of concern for traders, especially inexperienced ones.

    On 23 March 2018, ESMA issued some measures that change the rules for online brokers.

    The measures adopted include:

    • A ban on the marketing, distribution or sale of binary options to retail investors
    • The restriction on the marketing of CFDs and more specifically: The protection of the negative balance, The closing of the margin for the account; prevent the use of incentives and bonuses, a specific warning on risks clearly provided and the limits on leverage.

    The current leverage limits provide for a maximum leverage of 30: 1 while previously it could reach up to 400: 1.

    leverage

    Conclusions

    This guide should have clarified your ideas regarding Leverage and its use in online trading.

    Always remember to use it in moderation, always leaving enough margin on your account to swing prices.

    To practice using the Leverage without running any risk, it is advisable to start with the Demo accounts offered for free by the online brokers we have proposed. When you are familiar with this trading tool, you can switch to real accounts, making the minimum deposit required by the chosen Broker.

    Here are the official links to access the Demo accounts of the best online brokers for free:

    What is Leverage?

    Leverage is a tool that allows you to make investments with capital lower than those required for the operation itself.

    How is leverage used in trading?

    In trading you can do operations with leverage up to 30: 1

    What limits are there to the financial leverage?

    The limits imposed by ESMA on financial leverage allow us to offer online trading with a maximum leverage of 30: 1

    How to use the leverage?

    Just use an online broker like eToro, which allows you to take advantage of leverage without paying commissions.

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