What is leverage? The meaning of leveraged trading and types of high-leverage investment tools.

In the financial markets, many investors are using leveraged trading, with Margin Trading and day trading being particularly mainstream. If the market moves as expected, the ability to multiply investment returns using leverage is certainly appealing!

But in reality, leverage is a double-edged sword. If the market reverses, not only can profits be wiped out, but there is also the possibility of losing the principal.

This article delves into the advantages and disadvantages of leveraged investing, and introduces practical strategies and techniques for effectively utilizing Margin Trading in the stock market.

What is Leverage Trading?

Margin Trading is a system that allows for large transactions with a small amount of margin by "borrowing money" at the time of trading. The goal is to aim for a large return with a small amount of capital. Just as Archimedes discovered the principle of leverage and said, "Give me a place to stand, and I shall move the earth," the power of leverage in financial markets is also astonishing. If you invest a total of 1,000,000 yen by borrowing 900,000 yen with your own capital of 100,000 yen, that represents a leverage of 10 times.

The leverage tools commonly used by investors are as follows:

• Margin Trading: Borrowing funds from a brokerage to buy more stocks.
• Use of Derivatives: Futures, options, CFDs, etc., all of which have leverage effects.

Companies also utilize leverage through debt financing. Individuals also engage in leverage operations with mortgages, right...

Robert Kiyosaki, the author of "Rich Dad Poor Dad," states, "A loan is not necessarily a liability. If an investor wisely uses a financial mortgage, borrows money to further utilize it, and even renovates the purchased house to earn rental income, is this an asset or a liability?"

Using cash to generate a continuous cash flow—this is the essence of leverage.

The Principles of Leverage Investment

When it comes to leverage, margin comes to mind, but while these two are related, they are different concepts.

"Leverage actually means taking on debt, and margin refers to the funds that investors deposit as collateral to obtain a position".

Let's explain the principle of leveraged investing using the Taiwan stock index futures as an example:

The recent closing price of the Taiwan Stock Index futures is 13000 points, and the value per point is 200 yuan. Therefore, the total value of one contract of the Taiwan Stock Index futures is:

13000 points × 200 CNY/point = 2600000 CNY

In futures trading, you do not need to pay the full amount of 2.6 million yuan; you only need to prepare part of the funds as margin. If the margin is 136,000 yuan, then your leverage ratio is:

Total Value ÷ Margin = 2600000 CNY ÷ 136000 CNY ≈ 19.11 times

This means that approximately 20 times leverage is being used, controlling assets worth 2.6 million yuan with a capital of 136,000 yuan.

Leverage Earnings and Risks:

Case 1: If the Taiwan Stock Index Futures rise by 5%, the profit is: (13,650 - 13,000) × 200 TWD/point = 130,000 TWD

• In other words, with a principal of 136,000 yuan, you earned 130,000 yuan, resulting in a return of about 96%!

Case 2: If the Taiwan Stock Index Futures drop by 5%, the loss will be: (13,000 - 12,350) × 200 TWD/point = 130,000 TWD

• In other words, the principal could be almost entirely lost, leaving you with nothing.

Risks of Margin Trading

Margin Trading carries high risks, and especially when the market is highly volatile, the prospect of "forced liquidation" is frightening. If investors cannot replenish their funds quickly, the brokerage will forcefully realize the losses to avoid its own losses. This situation is referred to as "forced loss cut" or "loss cut."

Recently, young people tend to leverage with the mindset of "if you win, you make a big profit; if you cut losses, you just need to add more money", but the market is cruel.

There is an actual liquidation case of the Korean YouTuber "Satto". During a live stream in 2022, he lost over 10 million dollars in just a few hours while taking a "high-leverage long position on Bitcoin". He anticipated a rise in BTC and took a long position with 25x leverage at a price of $41,666, but afterwards Bitcoin dropped below $40,000, and since he added more leverage long positions, he was liquidated again.

This story reminds us that the uncontrolled abuse of leverage and immature trading strategies can be fatal mistakes, regardless of what is being traded.

Advantages and Disadvantages of Leverage Investment

Advantages of Leverage Investment

• Improvement of Capital Efficiency: By allowing large trades with a small amount of capital, it significantly saves on trading costs and enhances capital efficiency.

• Increase in Profit: Without leverage, the funds and the trading products will be the same amount, but by using leverage, you can trade products worth $1,000 or even $10,000 with $100, and if you make a profit, it can increase by several times.

Disadvantages of Leverage Investment

• Increased risk, higher probability of liquidation: The greater the leverage, the higher the probability of liquidation even with the same position size.

• Expansion of Loss Rate: When trading with leverage and incurring losses, the loss rate also expands, resulting in a larger loss in the account. Therefore, risk management and appropriate stop-loss measures are very important.

Types of Leverage Investment Tools

As major leveraged investment tools, there are futures, options, leveraged ETFs, and CFDs. Additionally, margin trading in the stock market is also a type of leveraged trading.

If you are using leverage, it is important to prepare sufficient funds and to set stop-loss points and take-profit points in advance, regardless of the leverage ratio.

Conclusion

According to Robert Kiyosaki, using moderate leverage is one of the good ways to increase returns, but it is important how wisely you manage borrowed money to increase wealth. Once you start leveraging, both risks and returns are magnified. Especially when leveraging volatile products, there is a possibility of being cut off in an instant, so when starting Margin Trading, first practice with low leverage and always remember to set stop-losses.

Leverage carries high risks, but if it is used to increase returns while controlling those risks, isn't there no problem with that?