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Lesson 9: Leverage

Lesson 9: Leverage

Leverage is a key feature of CFD trading. Here is a guide to making the most out of leverage – including how it works, when it is used, and how to control your exposure.

Leverage is commonly believed to be high-risk because it magnifies the potential profit or loss that a trade can make. 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 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 exposure in check.

What is Leverage

Leverage is a facility that enables you to get a much larger exposure to the market you are trading than the amount you deposited to open the trade.

Leverage works by using a deposit, known as margin, to provide you with increased exposure to an underlying asset. You are 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.

Often the more volatile or less liquid an underlying market, the lower the leverage on offer to protect your position from rapid price movements. On the other hand, extremely liquid markets can have particularly high leverage ratios.

Forex trading comes with some of the highest margin ratios in the financial markets. The leverage difference between forex and stocks, for example, is much higher. Stock market leverage starts at around 5:1, which makes trading within the share market slightly less prone to capital risk. Leverage in Forex is up to 30:1 for the most liquid currency pairs.

For example, let’s say you want to buy 100 shares of a company at a share price of $50.

To open a conventional trade with a stockbroker, you would be required to pay 100 x$ 50 for an exposure of $5.000 (ignoring any commission or other charges). If the company’s share price goes up by $10, your 100 shares are now worth $60 each. If you close your position, then you’d have made a $1.000 profit from your original $5.000.

If the market had gone the other way and shares of the company had fallen by $10, you would have lost $1.000, 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 $5.000 exposure, or $1.000, to open the position.

If the company’s share price rises to $60, you would still make the same profit of $1.000, but at a considerably reduced cost.

If the shares had fallen by $10 then you would have lost $1.000, which equals your initial deposit.

Leverage and margin in trading

Margin is the actual cash portion of your position; it’s a security deposit set aside from your total account as a provision against loss and the need to repay the borrowed funds. Leverage and margin are just two ways of viewing the amount of borrowed funds used to magnify your gains or losses, your opportunities, and risks.

Using a 30:1 leverage means you set aside a margin deposit equal to 3.33% percent, $1.000, of your total $30,000 position. That $1.000 allows you to control $30,000 of the EURUSD or $30,000 worth of Euros.

Leverage does not alter the potential profit or loss that a trade can make. Rather, it reduces the amount of trading capital that must be used, thereby releasing trading capital for other trades.

The higher the leverage or lower the margin in online trading, the greater the maximum exposure you can get and the greater the reward and risk. Your trading margin is not your maximum loss. Instead, it’s the minimum amount you need to open a position and keep it open. If the price moves against you, your broker will automatically set aside more cash and increase your margin deposit to cover that drawdown in your account.

Your maximum loss per trade depends on where you have set your stop-loss order, the size of your position, and whether you had enough cash in your account to cover that loss and any others you may be taking. If you didn’t, your broker can terminate some or all your positions to keep your account from going below zero, via what is called a margin call.

What does a margin call mean in forex?

Any deposits used to keep positions open are held by the broker and referred to as ‘used margin’. Any available funds to open further positions are referred to as ‘available equity’ and when expressed as a percentage, ‘margin level’.

A margin call occurs when your margin level has dropped below a predetermined value, where you are at risk of your positions being liquidated. Margin calls should be avoided as they will lock in any of the trader’s losses, hence the margin level needs to be continuously monitored. Traders can also reduce the chance of margin calls by implementing risk management techniques.

Which markets can you use leverage on?

Some of the markets you can trade using leverage are:

Indices

A stock 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 (Exchange Traded Funds).

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 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 trading cryptocurrencies, such as Bitcoin and Ethereum, without tying up lots of capital.

Find out more information on the markets you can trade using leverage.

Leverage in Trading: Greater Risk or Reward?

Leverage is a dual-edged sword that can work for or against you. The easy availability of leverage in forex, stock, commodity, or crypto markets is what attracts the risk seekers and repels the risk-averse investor. Leverage is neither inherently good nor bad by itself. It is easy to learn how to use it if you have enough training, self-control, and common sense needed to wield it without hurting yourself. Those lacking any of the above should avoid it until successful using practice accounts; otherwise, the results will be gruesome.

Understanding the leverage meaning is one of the primary characteristics that separate the winners or future winners from the eternal losers on whom the others can feed.

The reality is that professional traders trade using leverage every day because it is an efficient use of their capital. There are many advantages of leverage trading, but there are risks whatsoever. Trading using leverage allows traders to trade markets that would otherwise be unavailable, like the forex market.

Leverage also allows traders to trade more lots or index contracts or shares than they would otherwise be able to afford. However, the one thing that leverage does not do is increase the risk of a trade. There is no more risk when trading using leverage than there is when trading using cash IF you control the risk per trade (1 to 3 percent) using proper position sizing.

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:

Greater reward

With a limited amount of capital, traders can control a larger trade size. This could lead to bigger profits and losses as they are based on the full value of the position.

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:

Greater risk

Because your initial outlay is smaller than conventional trades, it is easy to forget the amount of capital you are placing at risk through. So, you should always consider your trades in terms of their 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 from 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 a 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

Tips to mitigate risk in leveraged trading

Having an effective risk and money management strategy in place is essential for using leverage in forex and any other market. High leverage CFD brokers usually provide key risk management tools, including the following list, which can help traders to manage their risk more effectively.

Position size

Position size is usually the easiest one to keep your maximum loss risked per trade in control and, at times, is the only one. Your position size is how many lots (micro, mini or standard) or contracts you take on a trade.

Proper position sizing is key. Establish a set percentage you'll risk each trade; 1% is recommended. Then note your pip/point risk on each trade. Based on account risk and pip/point risk (stop loss) you can determine your position size.

The smaller the position size, the lower the risk because we reduce the following:

  1. The value of each pip/point.
  2. The cost of each 1 percent moves against you.
  3. The potential loss if your stop-loss order is hit. We measure risk not by the total position size but by the potential loss if your stop order is hit.

Yes, smaller position sizes mean lower profits when prices move in your favor. However, the priority is to keep losses low. Always.

Stop-loss orders

A stop-loss order aims to limit your losses in an unfavorable market by closing you out of a trade that moves against you at a price that is specified by the trader. This tool will work under normal market conditions.

With CAPEX.com you are specifying the number of pips, percentage from your account, or amount in USD you are willing to risk on the trade. However, even if the stop-loss is in place, the close-out price cannot be guaranteed due to slippage.

A trailing stop-loss works similarly to a regular stop-loss. However, when the market moves in your favor, the trailing stop-loss moves with it, aiming to secure any favorable movement in price.

High leverage forex broker

At Capex.com, we offer extremely competitive spreads, margin rates, and leverage ratios on over CFDs on +2000 instruments, including currency pairs, indices, shares, commodities, ETFs, and cryptocurrencies.

  • Familiarise yourself with our high leverage trading platform, WebTrader. Our award-winning platform comes with price projection tools, trading charts and graphs, drawing tools, and multiple Stop Loss options to ensure that you perfect using leverage in forex and other markets.
  • Get started now by opening a live account
  • Why not practice first with virtual funds on our demo account?
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