Definition of leverage trading and its formula
A clear-cut definition of leverage trading is the process where a trade is entered by a trader with a higher position size in respect to their account balance. The formula to calculate a position size is the following, L = A / E Here, L, represents Leverage and E (Equity) is the amount of Margin associated to the trade, divide this by the asset will formulate a Leverage Ratio. This ratio is of significance as the ratio will have a direct impact on key components of the trade such as liquidation levels.
How leverage trading differs from other forms i.e. spot trading
Overall, Leverage trading is a widely used method by traders around the globe because of the magnified gains it can produce. When compared to other trading methodologies, it is by far one of the riskier endeavours. This is because, big gains can also lead to big losses if risk is not managed properly. In comparison to Spot Trading, leverage trading is traded in contracts and not the underlying asset. Traders don’t physically own the asset in a leveraged position as they would in a Spot Position. There are many more conditions to a leverage trade, as discussed earlier, such as liquidation price points. A Spot Position does not include any liquidation price points. This means that the trader can hold on to that position for as long as they want whilst not having to worry about the current market conditions. In other words, leverage trading is not suitable for investments because wild market volatility can force traders to close their positions. Spot trading on the other hand is much more suitable for investing, as there are no underlying conditions that need to be met during market volatility. High leveraged trading has its time and place, they should only be performed with a proven trading methodology. Because of the risk’s involved, it is wise that traders only allocate a certain percentage of their portfolio to partake in this endeavour. Being able to grow that small percentage over time should yield confidence before putting more size on. A big mistake that novice traders make its that they trade to many big positions for the big gains. This usually ends up with them blowing their accounts, this sometimes is the cold hard truth about leverage trading.
Margin calls in leverage trading, how it works
Margin calls in trading only matter to leverage; it is, when an open position in an account falls towards a certain price point. To avoid liquidation of that specific position, margin maintenance is required. This essentially means that the trader must add funds to their account to keep the position afloat. Think of margin calls as servicing the open position, failure to do so will liquidate the position automatically. The bottom line is that margin calls need to be avoided by traders as they simply imply that the position is going against them. Adding to margin increases the position size naturally, meaning more risk is involved. Traders should monitor price movements on a regular basis and make informed decisions. If the trade is going in their favour, this eliminates the need for a margin call. However, if the trade trends against them and invalidates the trade, it is wise to cut losses before having to service a margin call. That is, market declines will greatly increase the probability of the trader needing to add additional size. Thus, more capital becomes necessary, again leading towards larger unnecessary size.
Liquidation levels in leverage trading
A Liquidation level represents a price point, if reached, the position will be automatically closed. The leverage formula helps to determine this level prior to traders entering the position. In essence, the liquidation level protects traders and the exchange, stopping them from magnifying losses after a specific price point. Traders have the option to add to their positions to reduce the liquidation level as the trade goes against them. This is done to avoid any margin calls and forced closure, it should not be done blindly, it should only be done if it is part of a trade plan.
A key concept here is the Leverage Ratio, the higher the ratio, the more magnified the position. This also means that the position will acquire much more risk compared to a position that how a lower Leverage Ratio. To put it in simple words, the higher the leverage ratio the closer the liquidation level. The lower the leverage ratio, the further away the liquidation price point from entry. Therefore, it is important for traders to assess trading plans and adjust the leverage used accordingly.