The impact of leverage on your trading
Leverage is, in general, a powerful and useful feature of CFDs and spread bets. It gives you the flexibility to take significant positions on key markets without tying up excessive amounts of capital, and magnifies the size of any profits you might make. However, leverage can be dangerous. If you are wrong about a trade, it acts to magnify your losses.
Using high levels of leverage
At excessively high levels (higher than those available at IG), leverage exerts another effect. In addition to simple magnification of P&L, it begins to materially damage your odds of success on any particular trade.
At IG we believe that all our clients should fully understand the impact of leverage, and the circumstances under which it can significantly damage the probability of a trade being profitable.
We also believe that allowing excessively high levels of leverage is not in the interests of our clients, our firm or our industry, and set our margin levels accordingly.
How does high leverage impact your trades?
This graph shows how excessively high leverage acts to distort the probability of your trade being successful. This distortion is the result of the way leverage interacts with transaction costs (spread, commission and funding).
In the absence of transaction costs, the leverage you use has no impact on your probability of success. If you were to place trades randomly, without any particular insight or skill, and aim to take profits of the same size as your maximum stop loss, you’d tend to win on 50% of trades and lose on 50% trades.
This would be independent of your leverage used, and is represented by the dotted horizontal line on the chart.
Transaction costs change this picture, representing a hurdle between you and a profitable trade. Another way of saying this is that costs shift the odds against you. At most levels of leverage this shift in odds is small.
However, when the leverage you use is so high that the margin supporting your trade is less than 10x to 20x your costs, your probability of losing begins to increase very rapidly.
This is because costs eat away at the supporting margin, leading to a high probability of being closed out. This is easy to understand if you think about the most extreme case, where your supporting margin is exactly equal to your transaction costs on a trade. You’d place your trade, and the transaction costs would leave you with zero supporting margin for your position. This would lead to you being closed out immediately, with 100% probability, every single time – regardless of your trading strategy or how the market moves.
How do we help prevent this from happening?
At IG we work hard to minimise the transaction costs you’ll pay, keeping our charges (not just spread and commission, but also overnight funding) at a very competitive level.
We also limit our maximum leverage, by product, to protect you from distorted win/loss probabilities on your trades.
The chart below shows the deposit-to-transaction costs ratio on some of our key markets, using the absolute minimum margin we allow and our standard transaction costs.
If you were to make even the most extreme use of leverage we permit, you’d be kept away from the zone where win/loss probability is significantly distorted.
What is the number one mistake traders make?
- We reveal the top potential pitfall and how to avoid it
- Learn from data gleaned from over 100,000 IG accounts
- Discover how to stick to your plan and increase chances of success
Setting realistic margin levels
In general we advise you not to use the minimum allowable margin as a matter of habit when trading – our minimum margins are set to give you flexibility when you really need it, rather than being the level of margin you should always be using in the normal course of trading. Our most successful traders, and longest-standing clients, tend to place significantly more money on deposit than strictly required by our margin rules.
Many firms offer far higher leverage than IG, allowing clients to trade in large sizes with much less margin on account. These firms sometimes also charge higher transaction costs, often in the hidden form of very high overnight funding charges.
The effect of this is to place their clients in the position of having a very high probability of losing on each trade. This ‘churn and burn’ business model sees the firm aim to make money by encouraging its clients to lose, meaning naive traders are treated as a commodity to be quickly and aggressively exploited, before being replaced by newly recruited replacements. We do not believe any CFD firm should act in this way.
Our business model is different. We hedge the vast majority of our net client exposure. This means there is no correlation between our revenues and our clients’ overall trading performance, and that there is every incentive for us to support you in your trading with us over the long term.
1 Based on revenue excluding FX (published financial statements, June 2020)