Have you ever wondered how you can trade cryptocurrencies while controlling positions much larger than the funds you have? Well, leverage is the answer. This financial tool allows you to maximize your gains, but it also comes with very high risks. In this article, we’ll learn what leverage is, how it works and who it’s suitable for.
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Ce este levierul ?
Leverage is a financial trading tool that helps you trade much larger amounts than the capital you have. Basically, you borrow capital from the broker or trading platform you are using, which allows you to open a larger position than you could with your own funds.
Leverage allows you to make a trade by depositing margin as collateral. A leverage of 1:10, for example, allows you to trade 10 times the amount of your deposit (margin). If you have 500 RON in your account and you want to trade bitcoin using a leverage of 1:10, the platform will allow you to control a position of 5,000 RON.
Using leverage can magnify both gains and losses, making it a “double-edged sword”. That’s why it’s essential to fully understand what leverage is and how it works before using it.
Quick tip: if you use leverage for a bitcoin position, you risk losing all your funds. As opposed to just storing those funds, which if the price went down and subsequently goes up you still own the cryptocurrency, whereas if you use leverage you lose the money completely and can’t get it back.
Care sunt functiile leverage
As we have seen, leverage is a powerful financial instrument that allows investors to control a greater amount of capital than they actually hold. Leverage performs a number of essential functions in trading.
Boosting profit potential
One of the biggest advantages of leverage is the ability to amplify profit potential. With a comparatively small investment, investors can generate gains that would be impossible without this strategy.
Example:
Let’s assume that an initial investment without leverage yields a 10% profit. If the basic investment is 1000 RON, the final gain will be 1100 RON (profit of 100 RON). On the other hand, using leverage (x5) and having access to a total investment of 5000 RON, the 10% profit will bring in 5500 RON (gain of 500 RON). Basically if with an unleveraged investment I have 100 RON profit, but if I have leverage x5 for the same investment the profit increases by almost 5 times.
But it’s important to understand the risks. If the market doesn’t perform as you expect, leverage can also magnify your losses. In that case you risk losing all your money very quickly.
Access to markets with low capital
To trade in markets like Forex or commodities, you usually need large amounts of money. Leverage allows you to participate in these trades, even if you have little capital. The reason why you need substantial funds to participate in such markets is the very small increase in the price of a purchased good or currency, which is why if you participate in a trade with a small amount, the profits are almost negligible. Thus many investors resort to leverage.
How does it work?
- Investors with just a few thousand dollars can access markets that would otherwise require tens of thousands of dollars, hundreds of thousands of dollars or maybe even millions.
- Brokers often offer leverage according to the investor’s needs, increasing the chance of participating in global transactions.
This makes investing more affordable, especially for those just starting out. At the same time for those who are sure of a “bet” it helps them to minimize their equity exposure by using borrowed capital.
Increase speed of response to opportunities
In financial markets, speed is of the essence. Rapid price changes can open short windows for significant gains. With leverage, investors can react faster and more forcefully to these opportunities.
Key benefits:
- Greater ability to close or open positions without waiting for equity to increase. Specifically, you can bet a large amount of money without having that amount available. Without having to bring in capital that you already have invested elsewhere.
- Faster access to the liquidity needed to invest in new market opportunities.
More efficient use of capital
Another significant benefit of leverage is that investors can diversify their portfolio without needing more personal capital. Instead of locking up the entire amount in one asset or a single transaction, leverage gives them the opportunity to invest in multiple assets simultaneously. Of course this option is also very risky.
How does diversification work?
- Split investments reduce the risk associated with a single asset.
- The ability to explore multiple markets (equities, currencies, commodities) improves the overall balance of the portfolio.
For example, an investor can use leverage to invest in shares in a particular economic sector, while also exploring the real estate market or cryptocurrencies.
Leverage is a valuable tool for increasing gains and diversifying investments. However, success depends on fully understanding the associated risks. Investors who inform themselves and use leverage carefully can turn this strategy into a significant advantage.
Riscurile efectului de leverage in investitii
Leverage can be an attractive tool for many investors. The possibility of multiplying your gains using just a portion of your own capital may seem like a unique opportunity. But like any other financial instrument, leverage comes with significant risks that should not be ignored. Here are the main risks associated with using leverage in investing and what you need to know to protect yourself.
Amplification of losses
Just as leverage can multiply gains, it can magnify losses. Imagine investing in a stock using 10x leverage. A fall in the share price of just 10% can result in a total loss of invested capital. Therefore, leveraged investors should be prepared for scenarios where their assets may underperform.
Example
If you invest £1,000 of your own money with 10x leverage, you have the equivalent exposure of a £10,000 investment. A small negative fluctuation of just 5% can mean a loss of £500, half of your initial contribution.
Margin call risk
When you trade with leverage, there are strict rules. If the market moves against you, the broker may ask you to deposit additional funds to cover your position. This is called a margin call. If you can’t respond quickly, the broker has the right to automatically close positions to limit losses – often at an unfavorable time.
Recommendation:
To avoid a margin call, make sure you always have a solid capital cushion for the unexpected.
Market volatility
Financial markets are highly volatile and leverage magnifies every small price movement. In times of economic instability, asset prices can swing dramatically, increasing the risk of losses on leveraged trades. A simple unexpected press statement or a celebrity tweet can cause price falls which, combined with leverage, can lead to huge losses in a very short time.
Additional costs
Leveraged trading may seem affordable at first glance, but it involves a number of additional costs, such as:
- Interest on borrowed capital
- Transactionfees
- Higherspreads
These extra costs reduce the profitability of transactions and can reduce the gains, especially for those who are not careful about contractual details.
Tip:
Carefully analyze your broker’s fee structure and check if you are using leverage to justify these costs.
Risk of over-indebtedness
Another major danger of the leverage effect is overuse. When investors use too much borrowed capital, they can end up in the difficult situation of over-leveraging, especially in the event of sudden market falls. To limit this risk, some brokers offer “negative balance protection”, which covers losses that exceed the original capital. However, not all brokers offer this protection
Practical example:
Imagine you have opened a highly leveraged position on a cryptocurrency. Although you set a stop-loss, the price falls so quickly that the order is executed at a much lower price. Under these circumstances, your losses exceed your initial capital and you now owe money to the broker.
Lack of experience and knowledge
Managing leverage requires a high level of understanding of the financial market as well as a clear knowledge of the risks. Inexperienced investors can quickly fall into the trap of overestimating potential gains and underestimating risks.
Recommendation:
Start experimenting with minimal exposure and low leverage to gradually build your confidence and trading knowledge.
Emotional risks
Finally, we cannot ignore the impact that leveraged investments can have on the psyche. Decisions guided by fear (panic selling) or greed can lead to costly mistakes. Market volatility, combined with leverage, amplifies stress and can prevent rational decision-making.
Practical tip:
Set clear rules before you trade, such as stop-loss thresholds or clear profit targets, and stick to them regardless of your emotions.
How to use leverage successfully
Leverage can be a valuable tool when used with care and good risk management. Here are some basic rules for using it responsibly:
- Get informed before you start; financial education is the key to success.
- Once you understand what leverage is and how it works, use a small leverage effect, especially if you are a beginner.
- Constantly monitor your positions and set clear limits for losses and gains.
If you want to learn more about leverage risks, in particular in the alternative investment fund (AIF) sector, I invite you to consult the final guidance published by ESMA: “ESMA publishes final guidance to address leverage risk in the AIF sector”.
Levierul: Strategii sigure pentru incepatori
If you’re thinking of venturing into leveraged crypto trading and you’re a beginner, here are three strategies that can help you:
Start with low leverage
For beginners, a low leverage such as 1:2 or 1:5 is recommended. Why? Because lower leverage gives you enough room to maneuver to understand the market and its workings without exposing yourself to significant risk.
Low leverage allows:
- Practice your trading strategy without risking major losses.
- Building confidence step by step in using this financial instrument.
- Limit rapid losses, especially in the event of sudden market movements.
Risk warning
Although the use of leverage can generate considerable profits, there is a significant risk of rapid losses. Market movements are magnified in proportion to the leverage used. So until you familiarize yourself with the dynamics of trading, keep things as simple and manageable as possible.
Educate yourself thoroughly
Knowledge is power, especially when it comes to leveraged trading.
It’s crucial to understand:
- What is leverage and its technical mechanisms.
- The risks involved, including liquidation of positions or maintenance margin.
- Risk management strategies that can protect you in an unfavorable market.
Trade with a demo account
One of the best ways to learn is through practice. Most trading platforms offer demo accounts that allow you to simulate trades using leverage without putting real money on the line. This is a safe and effective way to learn how the market reacts and how to manage your positions.
Invest the time to read educational materials, watch webinars or take courses that explain the basics of leverage in detail.
Manage risk carefully
Another key aspect of leveraged trading is risk management. You need a well thought-out plan to protect your investments and limit losses.
Use stop-loss orders
Stop-loss orders are essential tools to protect your positions. They allow the platform to automatically close your position if the market moves against you, preventing major losses.
Don’t invest more than you can afford to lose
A golden rule in trading is to never invest more than you can afford to lose. Market volatility can lead to rapid losses, and excessive use of leverage without having a clear knowledge of what leverage is can magnify this risk.
Constantly monitor the maintenance margin
Maintenance margin is the minimum amount you need to have in your account to avoid liquidating open positions. If your margin falls below this level, the platform may automatically close your positions, which can be disadvantageous.
Keep a transaction log
Monitoring your trades is a great way to learn from mistakes and improve your strategy over time. Write down all the key details, including why you opened a particular position, the results and lessons learned.
Key aspects to remember
- What is leverage: a financial instrument that allows you to trade larger amounts of money than you have in your account.
- What is margin: margin refers to the amount of money that an investor has to deposit as collateral in order to open a leveraged position.
- The purpose of leverage is to help you increase your trading gains by using more capital than you have available. Beware, leverage not only magnifies gains but also losses, so it is essential to use it with caution.
- Before using leverage, it is essential to fully understand what leverage is, the risks involved and risk management strategies.
- Leverage limits may vary by broker, financial instrument and local regulations.
- Be aware that crypto markets are open around the clock and volatility can be very high, including at night.
Is it the right lever for you?
Leverage is an advanced strategy suitable for investors who:
- Understand the risks involved and understand what leverage is
- They are willing to monitor the market continuously.
- Have a clear risk management strategy.
If you are just starting out or have low risk tolerance, it may be better to practice trading without leverage before venturing out.
If you would like to learn more about cryptocurrencies, you can find a number of resources with valuable information on blog Abarai. We recommend you read: