Risk and management of leverage trading
For those who are thinking about starting out with borrowed money to increase their buying power, there are several risks to be aware of and some tools of management. The most obvious risk is of course the risk of losing money. However, there are other more subtle risks that you should know. There is a risk of liquidation, unlimited losses, margin risks, and of course the well-known margin call.
Minimizing risks is the most important aspect of leverage trading and you should always use the proper risk management strategies. It’s not only about order types to protect you from unexpected losses, there are also strategies to avoid risk in regards to when you enter the market, how you enter the market, and where you are trading. A margin call calculator can be used to navigate your margin requirements and avoid getting a margin call.
Unlimited losses
Leverage should be used with caution when tried for the first time. If you are not careful your losses might mount up. The reason why it’s so risky is because of the high purchasing power which can sometimes be hard to control. Unlimited losses can theoretically incur if you are trading with a broker that does not operate with the right risk management systems such as stop-losses och negative balance protection. On some brokers or exchanges, it’s possible to lose more than your own money which would put you in debt with the broker. If you use very high leverage you can lose money in an instant.
Margin risks
When you trade with borrowed money you are putting down your own money as margin collateral which is always used first as risk. For example, if you have an account size of $1000 and you use a 1:50 leverage, your position size would be $50,000. If you maximize your purchasing power and enter the market with the full $50,000 you only need a 2% decline in the market to lose all your margin. This is the main risk when it comes to your margin capital.
To avoid risking your margin you can choose a lower ratio such as 1:5 or 1:10 and use a stop-loss to prevent unwanted losses. A stop-loss order is one of the best tools for any trader to control the risk. Even if you trade with the full size of $50,000, a stop-loss will stop you out at the smallest down movement of the market and your margin stays safe.
Margin call
A margin call occurs when your losses are getting close to the full amount of your initial margin. For example, if you trade your $1000 with 1:10 leverage and the market moves against you, your capital will fall negative pretty fast. If your losses amount to close to $1000 your broker or exchange will give you a margin call saying that you are out of risk margin and your position is about to close out.
There are three ways to deal with a margin call. First, you can deposit more money to save your position and give the market more room to move and perhaps turn around. Second, you can close out your position immediately and save what’s left of your margin. Third, you can do nothing and pray to god that the market will spare you this time. The third option is the worst and should be avoided at all costs. If you have more risk capital to use you can choose the first option and deposit more money if you have strong conviction in your analysis of the market. If you don’t have more risk capital you should close out the position and take the loss.
Liquidation
Liquidation occurs after you get margin called and the market keeps going against you. Liquidation in leverage trading means that your position will get closed out and liquidated. Your position will close out in a loss and all your margin capital will be lost.
This is the worst-case scenario for any trader or investor and should be avoided. Liquidations happen when a trader loses control over the liquidation price and of the position either due to a lack of experience in how leveraged trading works or because of some other error in trade management.
The best way to prevent a liquidation is to always use a stop-loss order to protect the downside of your trade. With a stop-loss you are always guaranteed to get out of the market at your own will, counting with some slippage. If you are a beginner trader you should paper trade with leverage or demo trade with margin before you start to see how the market will affect your position size.
Related: Liquidation price calculator
