Trading with leverage or leverage – what's the point in a simple example

It is not uncommon in trading to hear about such a thing as trading with leverage or leverage.

For some, especially novice traders, this concept is so frightening that it sometimes pushes them away from everything that was so intriguing in stock trading before.

In fact, there is nothing complicated in his understanding.

Leverage in translation from English "leverage" means "lever action".

Let's look at a simple example of an exchange transaction, the meaning of trading with leverage or leverage.

In trading, opening positions is possible in two directions:

• long-term purchase of an asset with the prospect of its growth and earnings on it (bought cheaper, and then sold more expensive)
• short sale of an asset with the prospect of its fall and earnings on it (sold more expensive, then bought cheaper)

In both cases, it is possible to open a transaction with leverage or leverage.

The amount of leverage on the exchange is usually determined by the following values, depending on the type of asset being traded.

• 1x – 100% of the value of the underlying asset (the deposit amount corresponding to the transaction amount is required)
• 2x - 50% of the value of the underlying asset of the asset (the required deposit amount is two times less than the transaction amount)
• 5x – 20% of the value of the underlying asset of the asset (the required deposit amount is five times less than the transaction amount)
• 10x – 10% of the value of the underlying asset (the required deposit amount is ten times less than the transaction amount)
• 20x – 5% of the value of the underlying asset (the required deposit amount is twenty times less than the transaction amount)

Etc.

What does this mean?

For example, we decided to go long for Bitcoin (BTC), i.e. buy it with the prospect of subsequent sale at a higher price.

For these purposes, the exchange will offer you options for trading on this transaction with different leverage sizes.

So, choosing one of these options - 1x, 2x, 5x, etc., in fact means - for what amount of collateral you are ready to provide the risk of the transaction.

Let's say we don't want to take much risk, since the volatility of this asset is high (strong fluctuations in price over a short period of time) and choose 1x.

This means that, after opening such a transaction, it will be able to close spontaneously only if the amount of current losses on it equals the amount of collateral on it (taking into account the provided leverage).

That is, since the amount of collateral we have, with the selected leverage 1x, corresponds to the amount of our entire deposit, our margin of safety is quite large and with large drawdowns, the order (transaction) will not close, because the balance will have a positive balance.

Let's say we decided to buy two BTC (Bitcoin) at a certain time (01.01) at the price of 22 383.1 USD per unit. 2 units of this asset, in accordance with the selected leverage, will require us to have a deposit secured in the total amount of 44 766.2 USD. If there is such an amount on our account, we tear off the order (transaction).

Further, we see that in subsequent trading periods, the current price of BTC changes and, in general, a downward trend is traced, and by 01.07 the price reaches its minimum value of 12 785.3 USD, which in general shows a total loss on this date (-)19 195.6 USD. But the deal is not closed, because the margin of safety (with the selected leverage) is sufficient to hold such a risk of an asset falling (we withstand a drawdown of (-)20%). The percentage of collateral coverage of the current result of the transaction is greater than zero (57.1%).

And now let's assume that, under all initial conditions, we choose to trade in leverage in 5x. That is, we open an order for the same amount of asset, only with the necessary collateral 5 times less. And what we see.

The transaction would have been automatically closed already on 01.06 due to the fact that the amount of the current loss would have equaled and become greater than the amount of the collateral itself. As a result, the trading operation is closed and we have a net loss equal to the amount of our coverage (deposit) 8 953.2 USD.

The conclusion is that the deposit on the order (the required deposit) with a leverage of 5x is less than with a leverage of 1x, which means that the risk of closing and getting losses in this scenario is much greater.

We are beginning to understand the essence of leverage in trading, which is clearly visible on the example.

All this mechanism indicates that it is desirable for professional traders who understand and are able to hedge (insure) their risks with multidirectionally opened orders to use leverage in stock trading.  

On exchanges, the leverage mechanism is implemented using software algorithms, which allows you to automatically output the result of traders' work, due to which it is sometimes quite difficult to assess its impact.

Trading with leverage or leverage - what's the point in a simple example - Something like that!