What is leverage?
Leverage 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.
How does leverage work?
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. 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 10% on the same shares.
Here, you’d only have to pay 10% of your $1000 exposure, or $100, 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 cost.
If the shares had fallen by $0.20 then you would have lost $200, which is twice your initial deposit.
Which markets can you use leverage on?
Some of the markets you can trade using leverage are:
A share is a unit of ownership for a particular company, and is usually bought and sold on a stock exchange. You can use leveraged products to open positions on thousands of shares, from blue chips like Apple and Facebook, to penny stocks.
An index is a numerical representation of the performance of a group of assets from a particular exchange, area, region or sector. As indices are not physical assets, they can only be traded via products that mirror their price movements – including CFD trading and ETFs.
Foreign exchange, or forex, is the buying and selling of currencies with the aim of making a profit. It is the most-traded financial market in the world. The relatively small movements involved in forex trading mean that many choose to trade using leverage.
Cryptocurrencies are virtual currencies that can be traded in the same way as forex, but are independent of banks and governments. Leveraged products allow traders to gain exposure to major cryptocurrencies, such as bitcoin and ethereum, without tying up lots of capital.
Benefits of using leverage
Provided you understand how leveraged trading works, it can be an extremely powerful trading tool. Here are just a few of the benefits:
- Magnified profits. You only have to put down a fraction of the value of your trade to receive the same profit as in a conventional trade. As profits are calculated using the full value of your position, margins can multiply your returns on successful trades – but also your losses on unsuccessful ones. See an example of magnified profit
- Gearing opportunities. Using leverage can free up capital that can be committed to other investments. The ability to increase the amount available for investment is known as gearing
- Shorting the market. Using leveraged products to speculate on market movements enables you to benefit from markets that are falling, as well as those that are rising – this is known as going short.
- 24-hour dealing. Though trading hours vary from market to market, certain markets – including key indices, forex and cryptocurrency markets – are available to trade around the clock.
Drawbacks of using leverage
Though CFDs and other leveraged products provide traders with a range of benefits, it is important to consider the potential downside of using such products as well. Here are a few key things to consider:
- Magnified losses. Margins magnify losses as well as profits, and because your initial outlay is comparatively smaller than conventional trades, it is easy to forget the amount of capital you are placing at risk. You won’t be able to lose more than the balance on your account, but you should always consider your trade in terms of its full value and downside potential – and take steps to manage your risk.
- No shareholder privileges. When trading with leverage you give up the benefit of actually taking ownership of the asset. For instance, using leveraged products can have implications on dividend payments. Instead of receiving a dividend, the amount will usually be added or subtracted to your account, depending on whether your position is long or short.
- Margin calls. If your position moves against you, your provider may ask you to put up additional funds in order to keep your trade open. This is known as margin call, and you’ll either need to add capital or exit positions to reduce your total exposure.
- Funding charges. When using leverage you are effectively being lent the money to open the full position at the cost of your deposit. If you want to keep your position open overnight you will be charged a small fee to cover the costs of doing so.
Leverage and risk management
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 restrict 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.
This type of account ensures that your losses will not exceed the initial deposit required to open the trade, as all positions must have a guaranteed stop attached.
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.
What is a leverage ratio?
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 10% margin would provide the same exposure as a $1000 investment with just $100 margin. This gives a leverage ratio of 10:1.
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 particularly high leverage ratios.
Here’s how different degrees of leverage affect your exposure (and thus profit potential and maximum loss) for an initial investment of $1000:
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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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