Leverage in Trading: A Double-Edged Sword

What is leverage in trading?

Leverage in trading essentially represents a loan that allows you to control a much larger position with a reduced capital. This concept is inspired by Archimedes' principle: "Give me a place to stand, and I will lift the world." In financial markets, the power of leverage is truly impressive. For example, with €10,000 of personal capital and a leverage of 10:1, you can control a position of €100,000.

Traders typically use several leveraged tools:

• Buying on margin: borrowing funds from a broker to purchase more shares
• Use of derivative products: such as futures contracts, options, or CFDs, which naturally incorporate leverage.

Companies also leverage debt financing, just like individuals when they buy real estate with a loan.

Robert Kiyosaki, author of Rich Dad, Poor Dad, emphasizes that borrowing is not necessarily a negative debt. If an investor wisely uses a mortgage loan by reinvesting that amount and even receiving rents on that property, is it really a liability or rather an asset?

The true magic of leverage lies in using capital to generate a continuous flow of liquidity.

Fundamental Principles of Leverage

When talking about leverage, it is essential to distinguish between two related but different concepts: leverage itself and margin.

Leverage refers to the debt incurred, while margin represents the capital that the investor must deposit to maintain their position.

Here is a concrete example to better understand how leverage works, using futures contracts on a stock index:

Suppose the recent closing price of a futures contract on the index is 13000 points, with a value of 200 € per point. The total value of a contract is therefore:

13000 points × 200 €/point = 2 600 000 €

This means that purchasing a futures contract is equivalent to an investment worth 2.6 million euros.

In futures trading, you do not need to pay the full amount of €2.6 million, but only a fraction in the form of margin. If the required margin is €136,000, your leverage is:

Total value ÷ Margin = 2,600,000 € ÷ 136,000 € ≈ 19.11

You are therefore using a leverage of about 19:1, controlling 2.6 million euros of assets with only €136,000 of capital.

Leverage returns and risks:

Scenario 1: If the index increases by 5%, your gain will be: (13 650 - 13 000) × 200 €/point = 130 000 €

• With an initial capital of 136,000 €, you achieve a profit of 130,000 €, which is nearly 96% return!

Scenario 2: If the index falls by 5%, your loss will be: (13 000 - 12 350) × 200 €/point = 130,000 €

• You are losing almost all of your initial capital.

This example clearly illustrates that the higher the leverage, the more amplified the potential gains and losses are. It is therefore recommended to deposit more margin to reduce leverage and thus limit risks. Setting up stop-loss is also crucial to control the extent of losses.

Risks of Leverage Trading

Leverage trading carries high risks, particularly during significant market fluctuations. The most feared scenario is that of forced liquidation. If an investor cannot quickly replenish the necessary funds, the broker, to avoid its own losses, will proceed with a forced liquidation of the losing position, commonly referred to as "liquidation" or "margin call".

Many young traders are attracted by leverage, thinking "if I win, I win big, and if I lose, I don't pay back." Unfortunately, the markets are ruthless.

Here is a real example of liquidation: a Korean YouTuber named Satto, specializing in cryptocurrency futures trading, experienced a live liquidation in 2022 while betting on the rise of Bitcoin with a leverage of 25:1. In a few hours, he lost more than 10 million dollars. He had opened a long position at $41,666 per Bitcoin, but the price then fell below $40,000. He even increased his position with more leverage, which led to another liquidation.

This story reminds us that, regardless of the traded asset, the excessive use of leverage that one does not control and immature trading strategies can be fatal.

Traders must be fully prepared to face potential market fluctuations, avoid excessive leverage and overconfidence, and set stop-loss points to control losses.

Advantages and Disadvantages of Leverage

Advantages of leveraged trading

• Capital Utilization Optimization: Leverage allows small investors to make larger trades with less capital, significantly reducing transaction costs and improving capital efficiency.

• Profit Amplification: Without leverage, you trade with capital equivalent to the value of the product. With leverage, you can trade 10 or even 100 times the value of your initial capital, proportionally amplifying your profits in case of success.

Disadvantages of leveraged trading

• Significant increase in risks: The greater the leverage, the higher the proportion of your position relative to your account. With the same position, the higher the leverage ratio, the greater the risk of liquidation.

• Amplification of losses: In the event of an unfavorable movement, leverage also amplifies losses. Therefore, rigorous risk management and the use of stop-losses become essential when trading with leverage.

Leverage Trading Instruments

Leverage trading instruments allow investors to control a larger market value with relatively modest capital.

These instruments mainly include futures contracts, options, leveraged ETFs, and CFDs (Contract for Difference). Margin trading in the stock market also constitutes a form of leveraged trading.

Let's take a closer look at these four main leveraged instruments.

1. Futures contracts

Futures contracts (Futures) represent a commitment between two parties to buy or sell an asset at a predetermined price on a specific future date. Transactions are centralized on futures markets, with standardized contracts. Many international companies use futures contracts as hedging tools. The underlying assets can be currencies, commodities, stock indices, etc. For example, commonly found are:

• The metals (gold, silver, aluminum)
• The stock indices (Dow Jones, S&P 500, Nasdaq, Hang Seng)
• Agricultural products (wheat, soybeans, cotton)
• Energy (oil, natural gas, crude oil, coal)

Futures contracts specify the underlying asset, price, and expiration date. Before expiration, traders can choose to close their position or roll it over. On the settlement date, regardless of the current value of the contract, settlement occurs at the "settlement price" of the spot market. This means that in the event of significant fluctuations in the spot market, futures traders may face unpredictable settlement prices.

2. Options

Options, also known as "option contracts", are certificates that grant the investor the right to buy or sell an asset at a specific price in the future. Unlike futures contracts, which are relatively straightforward (long position to anticipate a rise, short position to anticipate a fall), options involve more complex concepts such as the strike price, contract multiplier, and require an understanding of the rate of return and options data analysis.

3. Leveraged ETFs

In the ETF market, terms like "leveraged ETF", "double leveraged ETF" or "simple inverse leveraged ETF" are frequently encountered. These products are all leveraged exchange-traded funds.

Leveraged ETFs are suitable for more aggressive investors. However, it is important to understand that these ETFs outperform during strong market trends but underperform in sideways or volatile markets. Their use is therefore primarily suited for short-term strategies.

Additionally, leveraged ETFs are often criticized for their high transaction costs, typically 10 to 15 times higher than those of futures contracts. It may be more economical to buy futures contracts directly. However, some investors prioritize convenience, in which case it is essential to consider the characteristics mentioned above.

4. Contracts for Difference (CFD)

Contracts for Difference (Contract For Difference, CFD) are currently the most widely used trading mode on international brokerage platforms. They allow traders to easily conduct two-way transactions (long or short) without holding the underlying asset or resorting to complex securities lending mechanisms. Unlike futures contracts, they have no settlement date, thus eliminating the need to manage position rollovers. CFDs are not standardized contracts and are not traded on centralized exchanges. Trading conditions may vary across platforms, offering greater product diversity and increased flexibility in contract specifications.

CFDs, through their margin system, allow trading various global assets such as stocks, precious metals, commodities, indices, currencies, and cryptocurrencies.

For example, if an Amazon stock costs $113.19, by choosing a leverage of 20:1 on a trading platform, you would only need $5.66 to trade one Amazon share.

Regardless of the chosen leverage instrument, using leverage involves borrowing funds, and traders must be aware of the risk of liquidation and have sufficient funds. Whether they opt for a leverage of 1:1 or 20:1, they must set up stop-loss and take-profit orders in advance to automatically close their positions when the price reaches certain levels, thus securing their profits or limiting their losses.

Practical Strategies for Leverage Trading

To succeed with leverage, experienced traders recommend several concrete approaches:

Adaptive Position Management

• Start with modest positions ( 1-2% of capital per trade )
• Adjust the size of positions according to the leverage used
• For a leverage effect of 10:1, reduce the position size to 0.1-0.2% of the capital

Dynamic Stop-Loss Technique

• Place an initial stop-loss at 1-2% of the entry price
• Adjust the stop-loss according to market volatility
• Use trailing stops to secure profits during favorable movements

Strategic Diversification

• Never concentrate more than 5% of total capital on leveraged positions
• Diversify asset classes to minimize correlation risk
• Combine short and medium-term positions to balance risk

Systematic Prior Analysis

• Check the market liquidity before using significant leverage
• Assess historical volatility to adjust the appropriate leverage
• Identify key support/resistance levels for stop placement

These practical strategies allow for transforming the leverage of a risky tool into a controlled instrument for capital optimization.

Conclusion

According to Robert Kiyosaki, moderate use of leverage can be an excellent method for increasing returns, but the key lies in the wise use of borrowed funds to grow one's wealth. Once you start using leverage, both risks and returns are multiplied, especially when leverage is applied to highly volatile products, which can lead to a rapid liquidation.

When using leverage, always start with a low ratio and never forget the importance of stop-losses.

Leverage carries high risks, but that does not mean it is inherently negative. If your leverage is used to enhance returns while managing risks, why not use it?