Most financial brokers allow you to use leverage to increase potential earnings. Of course, using leverage is a risky investment method, but it may be a good strategy if you have a solid position.
Before using leverage, you need to pay attention to some things. It is best to wait until you have investment experience before you consider using this option.
What is Leverage?
Leverage is any technique that involves the use of debt instead of your liquid cash when buying assets. For example, maybe you have $10,000 to invest. Using leverage can enable you to make a larger investment, perhaps a $40,000 loan of other people’s money (OPM). Therefore, the price of stocks, commodities, real estate, or other products that you control with your own $10,000 is four times the previous price.
If the investment yields a profit, a larger investment in this item will yield more returns than what you would have earned with your own money. On the other side of the coin, there is a possibility of losing more than if you were to use only your money.
Why Utilize Leverage?
The main benefit of using leverage is to increase your potential profit. If you invest with your own money, you can earn as much as possible with a 5% profit, but using leverage means you can make more investments, and a 5% return will translate into more profit.
Leverage also allows you to get exposure to investments that would require you to lock in a dangerous portion of your capital. This is especially useful for products such as futures or real estate, where a large initial investment is usually needed, and the potential returns make using the leverage worth it.
Are There Any Disadvantages?
The downside to using leverage is that your broker requires you to always keep a certain percentage of the loan in your account. As long as your investment yields good results, this is not a problem.
However, market volatility makes the use of leverage risky because buying futures contracts you are interested in may require more capital.
If this happens, your broker will issue a margin call and ask you to deposit more funds in your account to cover the minimum percentage required to remain in the account. This means that the market you invest in has undergone a considerable shift and may become very expensive.
How To Avoid Risk When Using Leverage?
There are some steps to help avoid losing money when using leverage:
- Wait until you have more investment and trading experience, and then rely on leverage. There is minimal room for error because the cost of a margin call can be high.
- Use leverage on relatively safe investments. If there are too many unknown factors, or you do not have a good reason to believe that an investment is safe, you may not be able to generate the expected return even if you use leverage.
- Create a comprehensive strategy. You should have an exit strategy that can reduce losses when you are close to a margin call. Encountering a margin call usually indicates that you made a mistake.
- When using leverage, carefully read the terms and conditions that the broker requires you to follow. You will learn more about margin calls and the minimum amount to keep in your trading account.
Ultimately, using leverage can lead to higher returns as long as you invest carefully and choose the right investment products or real estate. If things do not go according to plan, the use of leverage may have disastrous consequences. Therefore, it is vital to cultivate a detailed strategy and correctly assess the risks you are taking. These precautions can help you get the most out of leverage.
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