As discussed above, leverage has immense benefits, but its dangers can also be very daunting. When trading the markets, traders should, at the very least, aim for survival. In a market where there are endless opportunities, it is important to chase profits, but it is way more important to avoid devastating losses. This is why it is important to use low leverage when trading the risky CFD markets. Low leverage allows you to be exposed to the benefits of leverage, but not to its potentially overwhelming dangers.
Why Use Low Leverage
Here are some reasons why it is vital to learn how to use low leverage when you trade the global financial markets.
The main reason to use low leverage is to limit your losses. Leverage boosts your trading capital, allowing you to control a much larger position in the market with just a minimal outlay. Still, profits are based on the overall trading position rather than your capital outlay.
For instance, if you have $1,000 and are trading on leverage of 1:100, you are effectively controlling a position worth $100,000 in the market. The market only needs to make a move of 1% against you and you will have lost your entire capital outlay (1% of $100,000 = $1,000). You will effectively have lost 100% of your capital in just a single major move.
However, if you have $1,000 and trade with a leverage of 1:10, it will mean you are controlling a position of $10,000 in the market. A 1% move against you will result in a loss of $100 (1% of $10,000). This means that you will only have lost 10% of capital in that one trade.
Easy to Recover Capital
Losses are an inevitability when trading financial and digital assets online. Successful trading only means that your profits will be more than your losses. Low leverage allows traders to be able to recoup their capital losses as easily as possible.
Consider you have a capital outlay of $1,000 and trade with a leverage of 1:100. This means that you control a position of $100,000 in the market. A move of 0.5% against you will result in a loss of $500 (0.5% of $100,000). You will now have a capital of $500 ($1000 – $500). To get back to your initial capital of $1,000, you will have to earn 100% profits on your $500 account.
In contrast, if you trade with a leverage of 1:10, you will be controlling a position of $10,000 in the market. A 0.5% move against you will result in a loss of $50. You will now have a capital of $950 ($1000 – $50). To get back to your initial capital of $1,000, you will need to earn profits of about 5.26% on your $950 account.
Lower Transaction Costs
One of the silent killers of leverage is transaction costs. Typically, spreads are negligible when trading CFDs online. However, with leverage, the costs can add up and limit your profitability. Lower leverage helps to keep transaction costs low and prevent them from eating into your profits.
Take this case. You have a $1,000 trading account with a leverage of 1:100 and wish to trade the EURCAD pair which has a spread of 5 pips. On a standard lot (1 pip = $10), you will pay a spread of $50 ($10*5pips). You are already 5% down even before the market starts moving.
On the other hand, a similar trade with lower leverage of 1:10 will mean that you control a $10,000 EURCAD trade position in the market. On such a mini lot (1 pip = $1), you will pay a spread of $5 ($1*5pips). This is a transaction cost of 0.5% of your $1,000 account.
As observed above, lower leverage ensures that you will not have to be worried about transaction costs consuming part of your profits. This has multiple advantages. You can implement aggressive short-term trading strategies, such as scalping, where multiple trades are opened and closed within a trading session. You can also trade around volatile events, such as news releases because potential widening spreads will not have a big impact on your bankroll. Additionally, you can also open multiple trades in different markets without worrying about massive transaction costs.
Peace of Mind
Emotions have been cited as one of the major reasons for traders losing their money when trading leveraged products such as CFDs. While emotions may be natural, bad emotions can lead to bad decisions in the market. You are more likely to succumb to bad emotions such as fear, greed, and bias when you have overleveraged your account and staring at a loss that is about to wipe out your account. By trading with low leverage, you will have the peace of mind necessary to make objective trading decisions in the market. In this way, you can gain a mental edge in the market, and prevent bad emotions from getting in the way of objective trading activity.
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