What is leverage?

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.

Unleveraged

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.

Leveraged

Find out more about how leverage affects your trading

Which markets can you use leverage on?

Some of the markets you can trade using leverage are:

• Shares
  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.

• Indices
  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.

• Forex
  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
  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.

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: