Understanding Stops and Leverage

This is for a friend and is a “simple” overview and not focused on currencies.

When you put a trade on and are going "long" or "up" on the charts, you are buying someone else's sell. This means that someone else has decided that the market is not profitable for them anymore. Say you wanted to buy some bitcoin at $1000... (as I type it is in free fall at 30k)
As I've established, when you Buy, you are buying someone else's Sell or if you are shorting, you are doing the opposite. Now assume there are practically infinite number of coins available at any price, this is functionally true in most cases for small traders. So, you buy at 1000 and take someone's sell, all good. You decide ahead of time that 1099 seems like a good place to get out of the trade, so you set a Take Profit (TP) at that price. You decide also that a stop of 899 would be good to avoid some random market fluctuations. You put $1000 of your money on the trade.

Now, importantly, you have not borrowed money for this trade (it is without leverage) so when you get to your TP then the sell and make a tidy profit. What happens if it goes the other way? You hit your stop and get out, hopefully a little wiser. It is important to understand that both the TP and Stop are the same thing; they are both Sells which other people are Buying. A market where there is plenty of action, ie people are constantly buying and selling is called high liquidity.

Now there are broadly speaking two ways this ideal world can fall down and both are low liquidity environments. In the above example, you put your stop at 899. This number is near a round number and is a factor of human emotional thinking (we like whole numbers; they are easier to understand). So, a whole pile of folks have put stops on around this price and a bunch more have put trades on to trigger a buy around this too. Very few people will have trades ready to trigger at a long distance from this value, for this demonstration then it will be below 800. Lets pretend that at 899 there is $500 worth of buys left (after all the other people have stopped out) and for the next 850 to 899 there are a total of $400 of buys, after that it is slim pickings. I’ve ignored Stop Hunting (the second way)

So your stop hits, someone buys at 899, then you keep selling at lower and lower prices. You hit 850 and you still have $100 left in the trade, (you can see where this is going). It then takes you all the way down to 800 or lower until you sells are completed.

Because you trade without leverage, you end up with a loss but that is it; even if the price goes down to half a cent before you finally get rid of that last $100.

This changes a lot with leverage. Leverage is borrowed from your broker automatically as you trade. In the above example, if you had 1:20 leverage, you would have put in $1000 of your money and borrowed 20k. This means more profit when the price gets to your TP is multiplied by 20, the obvious thing then is that your losses are also multiplied. This is okay in high liquidity environments as your stops will be promptly filled.

Say you have 4k in your account and the market falls, your stops fail because of low liquidity and you make a loss of more than 4k. This is where you need to know the fine print of your contract with the broker. They could theoretically chase you up for the extra.

So yeah, leverage can have some major downsides.

Traditional Currencies can also be dangerous even without leverage, in theory, as they are all relative to each other.

I hope this makes sense,
Cheers
MH

Stops are an important part of a trade. The stop is the point where a position goes from being long to being short. It's like a bridge, where you are borrowing on the future price of a security, so if that price falls, you don't have to pay the whole amount, but only the interest you owe. If it rises, you don't have to pay anything, because the price has already dropped from the level you borrowed from. In a way, stops and leverage are sort of the same thing.

Leverage comes into play during large pivots in a particular trade. When you look at long positions, this means that you're not only borrowing from the underlying asset, but you're also "leveraging" it by making your trades as large as possible. For instance, if you are long a stock, you may be worried that the price may fall to a low, so you make a trade that turns into a long position. The problem with this is that you are putting your entire account balance at risk, if the price moves against you. This is why stops and leverage are important in trades, because they help you to avoid taking large risks that could potentially wipe out your profits.

So what stops and leverage are, in the context of a trading strategy? They are two degrees of stopping power, where one stops you from taking a big loss and the other helps to prevent large gains from eroding your profit margins. Stops are there to take the risk of large losses, because otherwise you would just be risking more money than you're making. Leaning leverage on these trades, so that you are protecting your profits, is useful, but not really necessary, unless you want to become a very aggressive trader. Either way, two degrees of stops and leverage are a great way for a trader to stay within their means, while still making some consistent profits.