Leverage is a facility that enables you to get a much larger exposure to the market you’re trading than the amount you deposited to open the trade. Leveraged products, such as CFDs, magnify your potential profit – but also your potential loss.
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Leverage is a key feature of CFD trading, and can be a powerful tool for a trader. You can use it to take advantage of comparatively small price movements, ‘gear’ your portfolio for greater exposure, or to make your capital go further. Here’s a guide to making the most out of leverage – including how it works, when it’s used, and how to keep your risk in check.
Leverage works by using a deposit, known as margin, to provide you with increased exposure to an underlying asset. Essentially, you’re putting down a fraction of the full value of your trade – and your provider is loaning you the rest. However, your profit or loss is calculated based on the full value of your trade, so your losses can exceed your initial outlay.
Your total exposure compared to your margin is known as the leverage ratio.
For example, let’s say you want to buy 1000 shares of a company at a share price of $1.
To open a conventional trade with a stockbroker, you would be required to pay 1000 x $1 for an exposure of $1000 (ignoring any commission or other charges). If the company’s share price goes up by $0.20, your 1000 shares are now worth $1.20 each. If you close your position, then you’d have made a $200 profit from your original $1000.
If the market had gone the other way and shares of the company had fallen by $0.20, you would have lost $200, or a fifth of what you paid for the shares.
Or you could have opened your trade with a leveraged provider, who might have a margin requirement of 20% on the same shares.
Here, you’d only have to pay 20% of your $1000 exposure, or $200, to open the position.
If the company’s share price rises to $1.20, you would still make the same profit of $200, but at a considerably reduced initial outlay.
If the shares had fallen by $0.20 then you would have lost $200, which is as much as your initial deposit.
The majority of leveraged trading uses derivative products, meaning you trade an instrument that takes its value from the price of the underlying asset, rather than owning the asset itself.
The main leveraged products are:
Spread betting (UK only)
A bet on the direction in which a market will move, which will earn more profit the more the market moves in your chosen direction – but more loss if it goes the other way.
Contracts for difference (CFDs)
An agreement with a provider to exchange the difference in price of a particular financial product between the time the position is opened and when it is closed.
There are lots of other leveraged products available, such as options, futures and some exchange-traded funds (ETFs). Though they work in different ways, all have the potential to increase profit as well as loss.
Provided you understand how leveraged trading works, it can be a powerful trading tool. Here are just a few of the benefits:
Leveraged trading can be risky as losses may exceed your initial outlay, but there are numerous risk-management tools that can be used to reduce your potential loss, including:
Attaching a stop to your position can help limit your losses if a price moves against you. However, markets move quickly and certain conditions may result in your stop not being triggered at the price you’ve set.
These work in the same way as basic stops, but will always be filled at exactly the level you’ve set, even if gapping or slippage occurs. If your stop is triggered, there will be a small premium to pay in addition to normal transaction fees.
These accounts can help protect you, by ensuring that all your positions have a guaranteed stop, or are on inherently limited-risk markets.
Using stops is a popular way to reduce the risk of leverage, but there are numerous other tools available – including price alerts and limit orders.
Leverage ratio is a measurement of your trade’s total exposure compared to its margin requirement. Your leverage ratio will vary, depending on the market you are trading, who you are trading it with, and the size of your position.
Using the example from earlier, a 20% margin would provide the same exposure as a $1000 investment with just $200 margin. This gives a leverage ratio of 5:1.
Often the more volatile or less liquid an underlying market, the lower the leverage on offer in order to protect your position from rapid price movements. On the other hand, extremely liquid markets, such as forex, can have higher leverage ratios.
When researching leveraged trading providers, you might come across higher leverage ratios – but using excessive leverage can have a negative impact on your positions.
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Take our example from earlier. With a margin requirement of 10% and a full market exposure of $1000, you’d make a 200% profit on your initial outlay if the market rose by 20p – compared to just 20% from the conventional trade. But remember that it if the markets moved against you, your losses would be calculated using the same percentage.
Compare your profit to yout initial outlay if you used conventional trading:
And now with leverage trading:
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