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What is leverage in trading?

If you’ve recently started trading then you’ve probably come across a wide variety of jargon and one of the most important ones is “leverage”.

Of course, it isn’t immediately clear what this is so you may be asking yourself “what is leverage?” In trading, this can be a useful tool to help grow your wealth but there can also be significant amounts of risks involved.

If you want to maximise your returns with leveraged trading, it’s important to be able to make informed decisions before you use any of the many CFD trading platforms or Forex brokers available to investors in the UK.

Here is everything you need to know about what leverage is and how it can benefit you.

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What is leveraged trading and how does it work?

To put it simply, leverage trading (also known as margin trading) works by using a “margin”, a deposit, to give you more exposure to an underlying asset.

What this means is that you only have to put down a small fraction of the total value of your trade and your provider loans you the rest of the money. Your total exposure compared to your margin is called your “leverage ratio”.

Leverage can be something of a double-edged sword as, while it can help you to magnify your profits, it can equally increase your losses. This is why it’s important to use risk-management strategies if you’re considering it.

What is an example of an unleveraged trade?

Let’s consider an example of an unleveraged trade where you want to buy 1000 shares of a company whose shares are worth 100p each.

If you wanted to make this investment with a stockbroker, you would typically have to pay 1000 x 100p in order to get an exposure of £1,000. This is of course assuming that there is no commission or other charges.

If the share price of the company rises by 20%, each of your 1000 shares is now worth 120p. This means when you close your position you’ll have made a £200 profit from your original investment of £1,000.

However, if the company sees a fall in share price by 20%, you would lose £200 instead, or a fifth of your initial deposit.

What is an example of a leveraged trade?

Let’s assume that you had been in the same situation but wanted to trade with a leveraged provider, who had a margin requirement of only 10% on those same shares.

This means that instead of having to pay 100p per share, you only have to pay 10p each. This means it would only cost you £100 to open the position.

If the share price rises by 20% to 120p each, you would still have made the same profit of £200 but you would have been able to do so at a significantly lower cost. However, if the shares had fallen in value by 20%, you would have lost £200, or twice your initial deposit.

What is a leverage ratio?

A leverage ratio is a measurement of your trade’s total exposure compared to its margin requirement. This ratio often varies depending on the market in which you are trading and who you are trading with, as well as the size of your initial investment.

Using the figures from the earlier example, a margin of 10% would provide the same exposure as a £1,000 investment with a margin of just £100. This means you would have a leverage ratio of 10:1.

Typically, the more volatile the market is, the lower the leverage that will be on offer. This is to protect you from losing money rapidly due to fast price movements.

Conversely, extremely liquid markets can have very high leverage ratios.

One useful skill that you should know is how to calculate leverage, as this can be important when weighing up a potential trade. The following leverage ratio formula is commonly used and is also easy to remember:

L = A / E

L = leverage

E = margin amount (equity)

A = asset amount

Simply put, dividing the total asset amount by the margin amount gives you the ratio of leverage on a trade.

What markets can I use leverage on?

There are three main markets where you may be able to use leverage to increase your gains. These are:

Shares

As you may know, a share is a single unit of ownership in a particular company that can typically be bought and sold at any particular exchange. You can use leveraged products to open positions on a wide variety of shares.

These could be anything from penny stocks to the “blue chips” like Apple or Facebook.

Indices

An index is a representation of the performance of a group of assets in a particular financial sector. Since these aren’t physical assets, they can only be traded through an exchange.

Some of the most common examples of these are spread betting and contracts for difference (CFDs), which I’ll discuss more in a later section.

Forex trading

Foreign exchange, or “forex”, is the name for the buying and selling of currencies in order to make a profit and the forex market is one of the most-traded ones in the world.

As you might imagine, since there are only relatively small movements in this market, many people involved in forex trading choose to use leverage.

What are some leveraged products?

Due to the way it works, most leveraged trading typically involves an underlying asset that is affected by short-term price movements. As you might imagine, it’s much less suitable for anyone who wants to invest for the long term.

Two of the most common financial products that are often leveraged are:

Spread betting

This is a bet on the direction in which a market will move. As you might expect, with leverage you can earn more profit if the market moves in your chosen direction. However, if it goes the other way then there is the potential for losing money rapidly.

Contracts for difference (CFDs)

This is an agreement with a provider to exchange the difference in the price of a financial product between the time that a position is opened and closed. Leverage can increase the profit or loss that you make.

It’s important to note that one of the main differences between these two investments is that spread betting is typically exempt from Capital Gains Tax. Furthermore, it can only be done by customers who reside in the UK or Ireland, whereas trading CFDs can be done globally.

What are the benefits of using leverage when trading?

Whatever you’re choosing to trade, leverage can provide you with a variety of benefits, although it can also have drawbacks. Here are some of the key ways that leverage trading can help you:

Magnified profits

One of the main benefits of using leverage is that you only have to put down a small fraction of the value of the trade to receive the same profits.

Since your profits are calculated using the full value of a position, margin trading can multiply your returns when you make successful trades. Of course, they can also increase your losses if you make an unsuccessful one.

Gearing opportunities

If you use leverage, you free up capital that you could be using to make other investments. This is known as “gearing”

For example, if you had £1,000 in capital, leverage could potentially enable you to make ten investments of £100 each, rather than one investment of £1,000.

Shorting the market

Using leveraged products to speculate on potential market movements can enable you to make significant profits from markets that are falling and rising. This is known as “shorting”.

24-hour dealing

While trading hours typically vary from market to market, some of them (such as indices and forex markets) are typically available to trade at whatever time you like. This can potentially help you to invest more effectively as you can respond to market movements whenever you choose.

What are the drawbacks to using leverage?

While using leverage can have a variety of benefits, it can equally have a number of drawbacks. Some of these are:

Potentially greater losses

Just as leverage can increase your profits, it can also increase your losses if you make a bad judgment. Since your initial outlay is smaller, it can be easy to forget how much capital you are placing at risk.

Of course, while you won’t be able to lose more than the balance on your trading account, you should always consider your trade carefully if you have a potentially high risk of losing money. It’s important to note that a significant number of retail investor accounts lose money when trading CFDs.

You have no shareholder privileges

One of the main downsides of using leveraged products is that you give up any benefits of taking ownership of the asset that you buy. For example, it can often have implications on dividend payments.

Typically, instead of receiving a dividend, the amount that you’d earn is usually added or subtracted to or from your account, depending on whether your position is long or short, respectively.

Margin calls

If a trade isn’t successful, such as if your position moves against you, your provider may require you to put up additional funds if you want to keep the trade open. This is called a “margin call” and you may have to add capital to your account or exit some of your positions to reduce your total exposure.

Funding charges

As you might imagine, when you use leverage you are essentially borrowing money to open a full position at the cost of your initial deposit. This means that if you are hoping to keep it open overnight then you may be charged a fee to cover the cost.

How do I manage risk when using leverage?

As you may know, leveraged trading can be very risky as your losses can quickly exceed your initial outlay if you aren’t careful. Thankfully, there are a variety of risk management tools that you can use to reduce the chance of this happening, including:

Basic and guaranteed stops

If you’re concerned about a sudden market movement working against you, you can attach a stop to your position. This instructs your broker to sell a stock when it reaches a certain price. For example, you could set a stop-loss order for 10% below the price at which you bought it to limit your loss to 10%.

Guaranteed stops will always be filled at the exact level you’ve set, although you may have to pay a small premium. Basic stops typically do not have these fees but cannot guarantee that the stop won’t be affected by gapping or slippage.

Negative balance protection

Usually, UK regulation ensures that you cannot lose more than the equity available on your account. Taking out protection means that if your balance goes negative due to a trade going poorly, it will be brought back up to zero so you can continue trading.

Should I borrow from a broker?

All in all, the decision as to whether you should borrow from a broker and pursue a leveraged investment strategy comes down to you, your personal circumstances, and your tolerance for risk.

Leverage in trading inherently comes with greater risk than buying and selling investments with your own money. So, while this does come with the opportunity for greater returns, you may also be exposing yourself to more risk than you’re comfortable with or can afford.

If you’re unsure whether leveraged trading is right for you, you could consider working with a financial advisor to help you make your decision.

A financial advisor can look across your entire financial situation and tell you how much you can afford to invest and whether it’s a suitable investment choice for you.

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My summary

Overall, when it comes to leveraged trading, here are the key takeaways:

  • Leverage in trading is essentially using borrowed funds from a broker to buy investments in various financial markets.
  • If your leveraged trades perform well, you have the potential to make more money than you might by investing in more “traditional” ways.
  • However, this also means taking on the risk of losing more money if your investments don’t perform well.
  • It can be a useful strategy for buying and selling complex instruments, such as forex or CFD trading.
  • However, please bear in mind that many retail investors lose money on these kinds of investments, particularly CFDs, and so they are often only suitable for professional traders.
  • If you’re unsure whether leveraged trading is the right strategy for you, consider seeking financial advice from a professional.

Please note:

This article is for informational purposes only and does not constitute financial advice. All contents are based on my understanding of HMRC legislation, which is subject to change.

The value of your investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance. Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.

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