The Advantage Of Leverage In Trading
Submitted: 02 Aug 10 16:06
Last Updated: 02 Aug 10 16:07
 

Investopedia explains ‘Leverage’ as : The use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment.

Unlike Stock trading where the trader often needs to fork out in cash the full value of stock price, a leveraged instrument like Futures, only requires the trader to use a margin to control the full contract value. This allows the trader to have a small income outlay, but to be entitled to the full profit/loss of the actual transaction of the full value of the counter.

For example, a contract of E-mini Russell 2000 (ER2) Index represents 100 times the index price. If the index is trading at 500, the actual value of 1 contract of ER2 will be USD 50,000. In this case, the leverage is of the order of 100. Depending on the broker, you may need only a margin of USD500 to trade 1 contract. Thus if the index moves from 500.0 to 501.0, you will actually make USD100 (1 x 100). In the above example, a 0.2% move in the index has brought the trader an effective yield of 20%.

The power of leverage is a double edged sword. If the trader does not has a good exit strategy in case the price should move against him, the losses can be substantial. It is thus crucial that when one is considering trading a leveraged instrument, a sound trading system and loss management strategies has to first be in place.