What Is Leverage?
Leverage is simply an equity multiplier. Leverage let's you borrow money from your exchange in order to open a position. It is a great way to increase your equity and trade larger position sizes, but it's also a great way to lose your entire account balance in one fell swoop if you get liquidated.
Trading with leverage carries high risk and greatly increases your market exposure. You also have to consider the borrow fees on your exchange, which is usually a very small percentage of your borrow amount on a position, known as a Daily Interest.
How to trade with leverage
As a trader looking to turn your trading into a personal business, leverage trading should be treated as a tool, not a way to gamble larger positions.
How does this work?
Let's say you're using an ATR based stop loss method. We covered this in the Risk Management section that you can use Risk Based Compounding method and incorporate an ATR as your stop loss.
Here's the position size formula again:
Position Size = Equity * Risk Per Trade % / Stop Loss %
Let's use a real example where we have $1000 in equity, and we intend to always risk 2% of our equity per trade. The key word being always. We covered in Part 1 of this course why trading with the same risk per trade is an key component in your trading to ensure your equity curve is consistent and has a measurable performance metric.
With $1000 in equity and a 2% risk per trade, let's say we identify this stop loss in a real trade. This is a real trade I took.
You'll notice that the stop loss is set at 0.64%. Now that we have all the information about this trade that we need, we can calculate our position size.
Position Size = $1000 * 0.02 / 0.0064
Position Size = $3125
You'll notice that the required position size is GREATER than our available equity! This is where leverage becomes an integral part in risk management. We're not using leverage to INCREASE our risk, we're using leverage to GUARANTEE risk consistency!
We can easily calculate how much leverage we would need to open this trade using this formula:
Leverage = ⌊Position Size / Equity⌋
Using this formula, we can identify that our Leverage required to open this position will be 4x, as we will always need to round up one integer to reach the necessary leverage.
Leverage = ⌊$3125 / $1000⌋
Leverage = ⌊3.125⌋ ≈ 4
Trading with leverage is a part of a professional trader's toolkit and should be treated as a method of guaranteeing consistent risk exposure across all of your trades, not gambling on the markets.
Using formulas described above, you can easily demonstrate that leverage is necessary if you are using Risk Based position size calculations if your Stop Loss % is ever less than your Risk Per Trade %, as the formula will always work out to have a position size greater than your equity.
ALWAYS use a stop loss when trading with leverage, as depending on how much leverage you've used, you may end up getting margin called, and this is NOT what we want, as you will wipe out your account! Remember, this is a SURVIVAL game.