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Learn how you can use leverage to gain a large exposure to a financial market with a relatively small initial outlay. Leverage can magnify your profits, but we explain that it’s important to use it with care, because it also increases your risk of loss.
|Introduction to leverage|
|What is leverage?Trading on marginHow leverage worksMagnified profits and lossesThe benefits of leverageWho uses leveraged products?|
You always need to consider that leverage magnifies the scope for both gains and losses. Although there’s the chance you could book impressive profits, your potential losses are not limited to the margin you have put down.
Your maximum possible loss, viewed as a percentage of your investment, is greater when you trade using leverage. It should be noted, however, that the ultimate risk – the most you could possibly lose – is the same whether you buy the assets at their full value or just put up a margined deposit.
For this reason, it’s a good idea to think of your position in terms of its full value rather than just the amount of margin. You shouldn’t make a leveraged investment unless you’re fully prepared to cover any possible loss.
Let’s say BP is trading at 475p per share. You decide to buy 1000 shares in BP at this price.
If you were to buy the full value of those shares, it would cost you £4750. Your ultimate potential loss, therefore, if BP’s share price falls to zero, is £4750. Viewed as a percentage, this is a 100% loss: your entire investment.
Using leverage, you could get exposure to the same number of shares in BP by putting down only a fraction of the full purchase price. With a popular share like BP, the margin might be as low as 5%.
This means you would put down 5% x 475p x 1000 shares = £237.50 for the same exposure as if you purchased the assets outright. If BP's price falls to zero, you'd lose £4750.
Your ultimate loss, whether you are buying outright or on leverage, is the same. This is calculated by multiplying the change in share price (475p – 0 = 475) by the number of shares (1000) = £4750. Viewed as a percentage of your initial outlay, however, if you are trading on leverage this is a 2000% loss.
Margin rates and slippage factors can vary, dependent on the regulatory rules governing the country in which your account is based.
Although leverage inherently involves some risk, there are numerous ways to manage that risk and limit your potential losses.
See our managing risk module for a full range of tools that are available to mitigate potential losses, including tools specifically designed for trading on leverage.