Understanding leverage

Leverage is a powerful trading tool and a key feature of several derivative products.

Think about it this way: when you buy a new car, you may not be able to pay the full amount right away. Often, you can choose to make a deposit and pay the rest off in instalments. Once the initial deposit has been paid, you can take possession of the vehicle and drive it around.

Trading using leverage works somewhat similarly. You’ll only need a small initial outlay to get greater exposure to the underlying market you’re trading. In trading, this deposit is called your margin.

In essence, your trading provider is lending you the difference between your margin and the actual cost of buying into the market.

Even though you only pay a fraction of your trade’s total value upfront, you’ll be exposed to the market based on the size of the full position. Just like when you pay a deposit on a car, you can drive out with it as if you owned it.

This means that using it could increase your potential profits. However, it can also amplify your losses.

This lesson will cover how leverage works in different situations, and how it may affect which products you choose to use.

Examples of leveraged products

You can take a leveraged position using a variety of derivative products, from simple spot trades all the way to complex options.

Remember, spot trading involves taking a position at the current market rate or spot price. These trades don’t have fixed expiry dates, but they do incur overnight funding charges. That’s why they could be useful for short-term trading, but not well suited to medium- and long-term strategies. The real-time prices closely track the underlying market.

A more complicated way to trade is using options. These financial instruments act as contracts, giving you the right, but not the obligation, to trade a particular asset at a set price and on a set date in the future. It costs a small premium, but you don’t have to complete the trade.

Futures contracts act as an agreement between two parties to exchange an underlying market at a set price in the future. These products also use leverage to increase your exposure to the market. Unlike an option, here the buyer and seller are obliged to complete the purchase or sale before or on the expiry date.

CFDs and spread bets are also leveraged. They too follow the underlying market’s movements very closely because their prices are derived from it. Like other derivatives, the price you pay to trade a CFD on particular market seeks to mirror any price movements of the asset itself.

Later in this course, we’ll delve deeper into all the different products (leveraged and non-leveraged) that we offer so that you can decide what’s best for you.

When using leverage works for you

As mentioned, leverage amplifies your exposure to a market, which means your profits and losses can be exponentially higher. Let’s see how that actually works.

Say you have £10,000 that you want to try and grow in the markets. You do your research and predict that stock XYZ plc’s price will rise soon. You have two options: buy the shares outright at their full value or trade on the market using a leveraged derivative instrument.

In a non-leveraged trade, you’d simply buy £10,000 worth of the XYZ plc’s shares. If the share price went up 10% and you sold them, you’d have £11,000 (ignoring any commission and other charges). Your profit would only be 10% of your initial capital, which is the same increase that the asset also experienced.

But what would happen if you instead chose to trade using a financial instrument that gives you leverage and has a 20% margin requirement?

The same £10,000 means you can now take a position worth £50,000, your provider having lent you the £40,000 difference.

If you were right about the asset’s price rising, the value will increase by the same 10%. The initial £50,000 position would now be worth £55,000. Remember, you only put down £10,000 for the trade and you’ve made £5000 profit – that’s’ a 50% return on your initial outlay. This is leverage at work.

When leverage works against you

Like with any stock market activity, there’s no guarantee you’ll make a profit. When you have a losing trade, leverage can magnify the negative effects as well. Let’s consider the downside.

Using the above example, let’s see what would happen if you’d invested in XYZ plc and its stock price depreciated. Had the shares from XYZ plc dropped by 10%, your £10,000 investment would now be worth £9000.

If you think the share price might increase in the long run, you could keep the position open. If you anticipate that it’ll never recover, you might want to close the trade to avoid losing any more of your money. With this method, you’ll only realise that loss once you sell the shares.

Had you made the trade using the same leveraged financial instrument as before and the market depreciated by 10%, the loss would be magnified. Your full position in the market would be worth £45,000.

That doesn’t seem so bad until you remember you put down £10,000 with 20% leverage, effectively entering a £50,000 trade. Your total loss would be £5000, which is half the original capital you’d put up. Even though you’d only paid a fraction of the total value of your position, you’re liable for the full loss.

The worst-case scenario when using leverage

When you trade with leveraged products, you could lose more money than you started with. Can you guess how that’s possible?

This is what would happen if, instead of a 10% fall, your position dropped by 25%.

Your initial leveraged trade of £50,000 would now be worth only £37,500 and the loss would equal £12,500. Remember, you put up £10,000 of your account’s funds. You’ve lost £2500 more than the money you put in, and you’d need to have enough funds in your account to cover that loss.

Luckily, before you lose your entire account equity, the losing position will trigger a margin call.

Typically, this means that you’ll be notified by your trading provider or broker if your position is losing money rapidly and the equity in your account is about to run out.

This signals that you need to close your positions because you’ll soon fail to meet the margin requirement to keep it open. If you don’t, your provider might also begin closing them for you to reduce this strain on your funds.

In the UK, negative balance protection prevents your losses from going beyond the funds you have on your account. This means that if the losses on your trades take you beyond zero, your trading provider is legally required to bring it back to zero, at no cost to you. It’s likely your positions will be closed before this can happen.

As a retail client, this applies to all your trades. However, if you’re a professional client, this may not always be the case.

When you’re just starting out, losses like these can be disheartening. Managing your actions and emotions when it happens is an important part of the psychology of trading. Therefore, trading with leverage requires discipline and know-how.

Experience and planning may help you prevent a trade from getting so bad that you lose more than you started with. For instance, you’d be better prepared to use stop-loss orders to set the maximum loss you’re willing to incur from a trade.

Sometimes markets become so volatile that even careful preparation isn’t enough, so it’s important to use leverage with caution.

The costs of leveraged trading

In the earlier example, you essentially borrowed money from your broker to open your leveraged trade. As in all financial situations, borrowing money carries a cost.

Some products will charge you to hold your position open after market hours. In this event, your trading provider will make an interest adjustment to your account, reflecting the cost of funding your position overnight.

This is why leveraged products like CFDs and spread bets can be better suited to short-term trades. Holding them for prolonged periods of time could end up costing a fair bit of money, reducing your potential profits.

There are other products, like futures or forwards, that don’t incur overnight funding charges at all because of how they’re structured. Instead, they have a wider spread (the difference between the buy and sell price quoted for an asset) which has the cost of overnight funding built in.

Here are some of other costs you can incur:

• Commissions (when you trade stocks using CFDs or when you invest in them)
• Borrowing fees (when you short a stock using CFDs)
• Currency conversions (when you trade in a currency other than your own)
• Extra services (eg live price data feeds and third-party charts)

The different charges will also depend on who you choose as your broker or trading provider and how they structure their product offering.

You don’t need leverage to be a successful trader

Without leverage, traders can buy the underlying asset without any loan component. Yes, this may reduce profits, but it may also reduce risks, including losing more money than you put up to open the trade.

For a trader starting out, avoiding leverage altogether might be a good idea. There’ll be enough to learn and manage without the added risks. You might also want to practise using a risk-free demo account to get a feel for what trading the markets is like.

As you get more confident, you could choose to add it to your strategy.

When you do decide to use leverage, you may want to consider how much you’re taking on board. A margin requirement of only 10% sounds great if you’re in a winning trade, but you could quickly wipe out your account balance if the markets move against you.

Whatever you decide, remember what you’ve already learned in this course. You can use your risk profile and your preferred trading and investing style to guide your choices.