Why Risk Management Is a Priority With Leverage Trading?
Do you feel your trades are restricted by your account size?
Well! It’s the case for most of the traders. Your trades and investment decisions are controlled by your trading account size and resources.
Take a case where you have the chance to make 100% more profit on your trades. However, you need to deposit $500 in your trading account to get started. VFM Brokers offers a 100% tradeable bonus for deposits and top-ups on any deposit you make.
Though you keep making profits with your current account size you seem to get stuck and bag a big fish. This is where leverage comes into play.
In simple terms in leverage, you actually borrow money or other securities to buy more trades than you could afford with your present resources. On one side where leverage allows you to maximize profit, it doubles the loss possibilities too.
That is why risk management becomes 1st priority for traders when trading with leverage. Traders who safely trade with leverage by following strict risk management strategies succeed in increasing their buying power and returns.
However when you are trading with leverage you “MUST” know two things in-depth:
Different ways to use leverage to maximize your profits
Understanding winning risk management techniques.
Here we will guide you on how you can safely trade with leverage.
Understanding Leverage And Risk Management
CFD is a leveraged market. Here you can have $1000 in a trading account and can trade for $10000. Forex trading attracts high leverage trading. Indeed leverage is the way for limitless profits but one evil turn in the market will wipe away all your money.
It is extremely risky if you don’t clearly understand how it works. You can even lose more than what you can afford.
Let’s say you are trading on a leverage ratio of 100:1. Now here one pip loss is equal to $10. So if you incur a loss of 50 pips you will lose $500 and not $50.
However, the advantage of high leverage is that the market is liquid which makes it easier to cut out profitable deals quickly. But you should always keep in mind that if leverage can magnify your returns it does the same with loss too.
Let us take another example to understand why it is important to have risk management on your side when trading with leverage.
Let us say that you want to buy 1000 shares each of 100p. So your capital requirement is $1000. Now if the share price goes up by 20p you will get a profit of $200. In case of loss, you will lose $200 or 1/5th of what you invested.
But if you go for leverage trading with a margin requirement of 10% you will only have to pay $100 to open the position. Now in case of a 20p rise in share prices, you will still make a profit of $200. But if the share prices drop by 20p you will have to bear a loss of $200. The loss is double your original amount.
UK Financial Conduct Authority recently reduced the amount of leverage allowed to traders. This step was taken in the interest of the traders. Many traders lost their entire trading account in one swipe. They were trading with a very high leverage ratio.
You will be shocked to know that a broker allowed a trader to open an account of $5 billion on leverage accidentally in 2018. What happens next will shock you. The trader thought he was trading on a demo account. So he actually placed $ Billion worth of live orders on US and European equity futures. In the end, the trader made a profit of 10 million dollars. He only had $20k in his trading account. The trader was using the leverage of over 200 thousand times than his original deposit.
That is why you need to understand how to leverage margin trading and risk management works.
The European Securities and Markets Authority (ESMA) set restrictions on the leverage given by brokers in August 2018. The leverage restrictions for retail traders’ opening positions vary based on the underlying:
For major currency pairs, the ratio is 30:1.
For non-major currency pairs, the ratio is 20:1.
The European Securities and Markets Authority (ESMA) did this for a reason: retail traders, particularly novice ones, are notoriously lousy at managing leverage and frequently lose money as a result.
How Margin Trading Is Both Profitable and Risky?
Margin is money borrowed from a broker to purchase a security with the help of other securities in your brokerage account as collateral.
The minimum margin requirement is established at 50% by federal laws, which means you can borrow up to 50% of the price of securities you intend to buy.
Many brokers charge interest on margin loans, making leveraged investing more expensive.
If you have $20000 in your account you can buy 100 shares of a company where the value of each share is $200.
But if you use a margin of $20000 from your broker you can buy a total of 200 shares. Now in case of hype in price by $50 you will get to earn a profit of $10,000 in margin trading. But with the cash, you would have made only $5000 profit.
However, if there is a loss of $50 things might get ugly. On margin trading on such loss, you will lose $10000. But with cash trading, you will have a loss of only $5000.
Always remember that you will have to repay the money you borrowed from your broker. Also, there are times when even after selling all your shares you still owe money to the broker as you were playing on high leverage.
What Are Other Ways Of Trading With Leverage?
Another way to trade with leverage is to use options. 100 shares of the underlying security are normally involved in a single options contract. Purchasing an options contract allows you to control 100 shares for a fraction of the price of purchasing 100 shares of a corporation.
Let’s say you predicted that the price of ABC company will go down. now you go for sell call options on the stock for $40. Now if the option holder has the authority to buy shares from the option seller at the set price.
In case the share price remains at $41 and the option holder decides to use the option you will lose $100. Now imagine if the share prices were at $50 you would have lost $500.
This is how risky leverage gets. That is why it becomes a necessity to have a concrete risk management strategy when trading with leverage.
Winning Risk Management Techniques
Risk management protects your account from vanishing off. One or two bad trades can take away the hard work and all the profits you had made until now.
Especially when you are trading with leverage you need to have a proper risk management plan and follow it.
Here is how to can avoid the market fluctuations and risks:
The first rule of safe trading is “Plan the trades and trade the plans.” Choose your broker wisely after considering factors like charges and his catering domain.
Moving averages are the most common method for determining these points because they are simple to compute and generally followed by the market.
Stop-loss and take-profit levels can also be placed on trend lines of support or resistance. Connecting past highs or lows that happened on considerable, above-average volume can be used to create these.
For more volatile stocks, use longer-term moving averages to limit the likelihood of a meaningless price move triggering a stop-loss order.
To match target price ranges, adjust the moving averages.
Stop losses should not be less than 1.5 times the current high-to-low range (volatility) since they are too likely to be performed arbitrarily.
The stop-loss should be adjusted based on the market’s volatility. Stop-loss points can be tightened if the stock price isn’t moving too much.
Calculate your expected return so that you can minutely analyze and compare several trades before investing.
Follow the 1% rule. Only spend how much you can afford to lose. You should never put more than 1% of your trading account value in a single trade.
Never put all your luck in one pot. Always remember to diversify your investments across industries, market capitalization, and geographic regions.
If you’ve been permitted to trade options, you can employ a downside put option, also known as a protective put, as a hedge against losses from a losing trade.
All traders must be accountable for their own decisions. Losses are inevitable in trading, thus a trader must learn to accept them as part of the process. Losses are not the same as failures. Taking a loss too soon, on the other hand, is a sign of poor trade management.
VFM Brokers ensures that you have a profitable trading experience. Open your live trading account now.
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