In the past decades, leverage trading has become the norm. Even more, for example, even developing countries such as China, where leverage trading was not common, now have to adapt to international financial markets and reduce their restrictions on leverage trading if they want to increase their status on the capital market.
Leverage trading is so-called trading on credit. Leverage means "lever". This leverage arises when you invest on credit in the capital market. Why has leverage trading become so important?
Initially created for security reasons, the entire developed world now works with loans. If you want to build a house, this is done via a mortgage, the car purchase mostly in installments. So that everyone can afford a certain standard, this system has existed for many years. Of course, it also has advantages: If almost everyone can afford a certain standard, the economy also benefits.
However, the whole thing becomes problematic if the majority of these loans cannot be repaid. The great financial crisis that occurred in 2008 arose precisely for this reason. Many were no longer able to service their mortgage loans, which made systemically important banks insolvent at a stroke.
Derivatives are mostly leverage products
The famous bubble formation that occurs in an investment segment if it is not profitable Alternatives are available, or this segment promises enormous returns, is additionally supported by loan financing. Many derivatives also belong to the segment of credit-financed investment products, but are often structured differently.
For example, while CFDs (Contract for Difference) are based on real business, i.e. the broker should be buying or selling real shares in the background to hedge Options Derivatives that take place on the basis of transactions that have not yet been concluded.
Since the underlying transactions have not yet been concluded, only a margin is payable. Forex trading, i.e. currency trading, is also carried out on the basis of collateral. This results in the so-called leverage effect.
- A trader would like to buy CFDs on shares that cost 100 euros. The broker demands ten percent security from him. So the buyer of CFDs only pays 10 euros per share. If the share price now rises by 1%, i.e. to 101 euros, the buyer of CFDs has not only made 1% profit, but has already made 10% based on his stake of ten euros.
The leverage effect should therefore not be underestimated, which goes far into the four- to five-digit range - this effect is increasingly dominating the capital market. According to the Association of Derivatives, the proportion of derivatives traded is growing steadily and has even increased many times since the financial crisis. Is that dangerous?
Is the leverage effect dangerous for the capital market?
For this reason, many criticize derivatives trading; but also because speculation about derivatives outweighs real trading. Because the idea should be that in the end trading is based on real business. For example, if many pending derivatives transactions on gold outweigh the total amount of gold, there can be talk of a bubble that is not covered by real values - and the amount is growing steadily.
Therefore, it can be dangerous if the derivatives bubble bursts and many of the derivatives traders can no longer increase their security deposits. Depending on how the banks handle it, some systemically important institutions could falter.
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Are binary options also dangerous for the capital market?
In derivatives trading, however, the private and the distinguish institutional trading. Binary options trading is also subject to leverage and is based on margin trading in the background, only the proportion is quite small compared to the entire derivatives market. This does not result in major upheavals on the capital markets.
It is usually the large institutions that pose the risk of a crisis, because mostly derivatives are traded here that are not accessible to small private investors as a product, At the same time, sums are used that are beyond the investment power of a single private investor. This can be dangerous for the markets.
Binary options are also among the derivatives that have a leverage effect. And although the derivatives bubble is growing, these products tend to pose fewer threats to the markets. Since binary options are designed almost exclusively for private customers, the low level of trading activity alone is less relevant compared to the overall market. It usually becomes dangerous when large institutions trade derivatives among themselves, as happened before the financial crisis in 2008.