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Leverage

What is Leverage and its advantages and disadvantages

Leverage is one of the most widely used terms in financial transactions, which is essential for traders. Today in Danap we are going to take a deeper look at the concept of it, so stay tuned.

What is leverage?

Traders use leverage to maximize the return on small investments. Traders provide only a fraction of the capital needed to open a trading position. This capital is converted into a larger cash deposit through it. Their profits and losses are calculated based on the total value of the trading position.

If all goes well, the final return on that transaction will be much higher than the initial investment amount. If the trading process does not go as expected, you will face huge losses. Traders talk about it when they want to reach a large part of the market with low capital. It is used in some financial products such as option trades, derivatives, and CDF contracts.

Leverage has another definition; In fact, it also refers to a company’s debts relative to its stock value. If a company has a high asset or investment, it means that its commodity or stock has more debt than its stock.

It was a hot topic in the financial crisis between 2007 and 2009. Its direct association with risky behaviors that led to financial collapse led to its notoriety among traders. Of course, to this day, Burridge has regained its prestige and reputation.

What you need to know about Leverage

It is an investment model in which the trader will pay only part of the value of the position. The initial deposit increases through it and the trader can buy more shares. This small cash stock is known as the Margin Payment and is different from all other assets and markets in which you intend to trade.

A deep, floating and relatively calm market requires a lower margin (about 5 to 7% of the position value). While traders in a volatile market ask for a higher margin (about 10%). In addition, the margin rate will vary depending on the rules and regulations of the country in which your account is located.

Leverage and Margin

Although leverage and margin are related, they do not have the same meaning. When a trader opens a trading position, he raises the initial deposit amount using it to buy more shares. In other words, it means to increase the buying or selling power of financial instruments and is generally in the ratio of 1: 2, 1:50, and so on.

Margin is also the cash that a trader must pay to keep a trading position open. Margin acts as a guarantee to cover the risks of trading. In other words, a trader can use the margin to build it.

Benefits of Leverage

Leverage benefits apply to almost all types of assets, which we will introduce below:

Stock market traders can add it to their portfolios through futures, margin loans, and options trades. Traders, for example, can invest the same amount in futures contracts instead of buying 10,000 euros of a company’s stock. Thereby controlling more shares.

 Its opportunities are also in the bond market. Traders increase their market share by investing in cheap short-term trades and then turn it into a long-term investment at a higher rate. They will eventually benefit from the price difference between the two investments.

The Forex market is also one of the places where high leverage is offered. For example, some Forex brokers offer 1: 400 or more to their clients, which means that $ 100 turns you into $ 40,000.

Some companies use it to finance themselves, and traders will have indirect access to its opportunities by investing in them. Companies often use financial loans to develop new segments, thereby increasing their shareholder salaries. You can analyze the financial balance of companies to find out about their loans and debts.

Leverage rates and market fluctuations

Leverage investment is often referred to as leverage, which is calculated based on the amount of equity compared to assets. For example, if a trader invests 1000 1,000 in a financial position with a 1: 4 leverage, his capital will increase by 3000 3,000. In fact, for every $ 1 of liquidity, the investor can make a trade worth $ 4. So if the future investment makes a 10% profit, its stock value will also increase by 40% due to leverage.

Of course, keep in mind that the leverage ratio is a simple calculation and excludes Leverage costs. You can also get stock fluctuations by multiplying the relevant asset fluctuations at the leverage rate. An investment with a leverage rate of 4 times will fluctuate just as much. It indicates an increase in risk in Leverage trading.

How leverage works

Suppose you want to buy 1000 shares of Company X for 1 1, then you have to consider a total initial cost of 1000 1,000. If the value of each share increases by 20 pence, you can sell your thousand shares for 1200 pounds and as a result, earn 200 pounds (20%) profit.

The example mentioned was the normal process of buying stocks. but using Leverage you can trade shares of Company X by paying part of the initial cost (margin). If the margin is 10%, we should use the formula% 10% × 1 × 1000, which would be 100. In other words, you can buy a 1000 1,000 stock for 100, and if the stock trades at 20 1.20 with a 20 percent increase, you will make a  200 profit by selling a total asset of 00 1,200.

Benefits

Successful use of leverage brings great returns to investors. The advantage of the Leverage Index is that it frees up your capital and allows you to make much larger trades; In other words, you will be able to invest in a wider range.

In addition, if the assets of the leveraged investment are accompanied by a high rate, they will bring you much more profitability compared to long-term transactions. For example, if you take out a 10,000 loan at a 5% interest rate and then invest it in a 10% interest rate deal. You will make money from the difference between the interest rate and the interest rate (500). The profit of such a deal over 10 years will be around 64 9,648.

Disadvantages

One of the major disadvantages of Leverage is that you will not enjoy the benefits of full ownership of the property. If the investment fails, you will incur huge losses. For example, the financial crisis between 2007 and 2009 in the United States occurred due to the overuse of financial leverage.

To better understand the potential risks of leverage, suppose a  20,000 real estate investor buys 10, 200,000 worth of housing, but if the value of each home drops to 160,000, there are problems. You will face a lot of finances. In this case, the investor will face a loss of 2000% and will lose 400 thousand pounds. In addition, the investor has to pay the loan and insurance installments. The financial leverage is as profitable as it is sometimes very harmful.