Leverage is a major characteristic of CFD trading. It may be an effective tool for a trader. You can use it, I.e. financial leverage, To take advantage of relatively minor price movements, And “leverage” your investment portfolio to gain greater exposure, Or to increase your capital. Here’s a guide to getting the most out of leverage – including how it works. And when to use it, And how to keep risks in check.
How does the crane work?
Leverage works by using a deposit, Known as margin, To give you greater exposure to an underlying asset. In principle, You put in a fraction of the total value of your trade – and your provider lends you the rest.
Your total exposure compared to your margin is known as the leverage ratio.
For example, Suppose you decide to buy 1,000 shares of a company at a price of 100p.
To open a traditional trade with a stock broker, You will have to pay 1000 x 100p to be offered at £ 1000 (if we ignore any commission or other fees). If the company’s share price rises by 20p, Each of the 1,000 shares will be worth 120p. If you close your position, You will then have made a profit of £ 200 off the original amount, which is £ 1000.
If the market had moved the other way and the company’s shares had fallen by 20p, you would have lost £ 200, or a fifth of what you paid for the shares. You could open your trade with a leveraged provider, with a margin requirement of 10% on the same shares. In that case, you would have to pay Only 10% of your exposure of £ 1000, or £ 100, to open the position. If the company’s share price had risen by 120p, you would have achieved the same profit of £ 200, but at a much lower cost. If the stock had fallen by 20p you would have lost £ 200, which is equivalent to double Your initial deposit.
Benefits of using leverage
If you understand how leveraged trading works, This can be a very effective tool. Here are some of these benefits:
- Inflate profits . You only need to put a fraction of the value of your trade to get the same profit as in conventional trading. Since profits are calculated using the total value of your position, margins may double your returns on successful trades – but so can your losses on unsuccessful trades.
- Opportunities for risk reduction . The use of leverage may free up capital that can be used for other investments. The ability to increase the amount available for investment is known as reducing risk.
- Selling in the markets . Using leveraged products to speculate on market movements enables you to take advantage of bear markets as well as those that are rising – this is known as selling.
- 24-hour trading . Although trading hours vary from one market to another, some markets are available for trading around the clock, including the major indices, forex, and cryptocurrency markets.
The disadvantages of their use
Although, CFDs and other leveraged products provide traders with a host of benefits. It is important to remember that your losses may exceed your deposits. And take into account the potential downside when using these products. Here are some key things to keep in mind:
- Inflate losses. Margins inflate losses as do profits, As the initial outlay is relatively smaller than traditional trading. It is easy to forget how much you are at risk. Therefore, You should always take your trading into consideration. With regard to its total value and potential downside, And take steps to manage your risk.
- No There are shareholder perks available. When trading leveraged, you waive the privilege of gaining physical ownership of the asset. For example, using leveraged products may have repercussions on dividends. Instead of receiving dividends, the amount will be added to or deducted from your account, depending on whether your position is a long or short position.
- Margin coverage. This means that if the position moves against you, Your provider may require additional funds to keep your trading running. This is known as margin call. Either you will need to add capital, Or exit positions to reduce your overall exposure
- Finance fee. When using leverage, You are actually loaned out money to open the overall position at the cost of your deposit. If you want to keep your position open overnight, A small fee will be charged to cover costs
Leverage and risk management
Leveraged trading can be dangerous considering that losses may exceed your initial outlay, however, There are several risk management tools that you can use to reduce your potential losses. including:
Attaching a stop order to your position can limit your losses if the market moves against you. But the markets are moving fast. Your stop may be fired at a price other than you specified.
Guaranteed stop requests
This type of request works on the same principle as basic requests, however, It will be filled exactly, And permanently at the same level that you set, Even with the occurrence of gaps or the difference between the estimated cost of the transaction and its actual cost. You’ll pay a small premium if your stop is triggered, In addition to the normal transaction fee.
Limited risk account
This type of account guarantees that your losses will not exceed your initial deposit required to open a trade. Since all centers must be accompanied by a guaranteed stop request.
The use of collateralized stops is a popular way to reduce the risk of leverage, however, There are several other tools available including price alerts and limit orders.
What is the leverage ratio?
The leverage ratio is a measure of the overall exposure of your trade compared to its margin requirements. Your leverage ratio will change depending on the market you are trading in. And with whom do you trade, And the size of your position.
Using the example we saw earlier, A 10% margin will provide the same exposure as a £ 1000 investment, And that’s just a £ 100 margin. This results in a leverage ratio of 10: 1.
The leverage that protects your position from rapid price movements is often low. The more volatile or less liquid the market is. On the other hand, It may be for very liquid markets, For example, the forex markets, High leverage ratios.
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