What is leverage in trading?
By using leverage, you can gain exposure to larger trading positions with a smaller amount of capital. Leverage of 10:1 means that margin is one tenth less than transaction size to open and maintain a position. So, if a trader had an account value of £10,000, using leverage, they could enter a trade for £100,000.
The margin amount refers to the percentage of the overall cost of the trade that is required to open the position. The margin requirement for a trade of £10,000 using a leverage ratio of 10:1 is $1,000.
When trading contracts for difference (CFDs) in financial markets, leverage is used. You can trade CFDs across a variety of financial assets, including forex, indices, commodities and shares. Of course, some markets are more volatile than others. Leverage may therefore be limited to smaller multiples of capital. In forex leveraged trading for example, retail leverage rates can start at around 30:1, compared to around 5:1 for shares. You can also find different leverage rates depending on whether you are a retail or professional trader. While retail leverage rates for forex are around 30:1, they are around 500:1 for professional clients. To qualify for higher leverage rates, professional clients must meet strict criteria.
Leverage can sound like a very appealing aspect of trading, as winnings can be immensely multiplied. But leverage is a double-edged sword – it is important to remember that losses can also be multiplied just as easily.
How to trade leverage
Understanding CFD margins, leverage, and the difference between them can be confusing. It is important to know that margin is the amount of capital required to open a trade. Leverage is the ratio applied to the margin to determine the size of the trade. Leveraged trading in financial markets is more likely done by those who trade short-term price movements and by day traders. It is not very suitable for those who make long-term investments such as several years or even decades. In this case the "buy and hold" approach is more appropriate. Given the short-term duration of most currency and CFD trading, it makes sense to use leverage to increase your trading ability.
It is important for all traders to keep in mind the risks involved in trading with leverage. Many financial market traders find that their margins are being wiped out incredibly quickly due to excessive leverage. Beginners should be extra careful when trading on margin. It is best to be more cautious and use less leverage. Low leverage means that traders are less likely to wipe out all their capital if they make a mistake.
Traders are advised to start with a leverage lower than the maximum allowed leverage. This allows traders to keep their positions fully open even in the face of negative returns. For example, suppose a trader has his maximum leverage of 10:1 and opens a position with that leverage on a $10,000 account.
The trader currently has a position size with an equity value of $100,000. This means that a 1% price move will completely wipe out your position. Also note that the broker can reduce a trader's position if the position has lost his $5,000. This is because the trader has only $5,000 of available capital and a leverage of 10:1 means the maximum position allowed is $50,000 instead of $100,000.
With reduced leverage, with an initial investment of $10,000 he goes 5:1, the position is $50,000 and a 1% move is $500. Keeping leverage ratios low means that traders are less likely to wipe out all or most of their capital if they lose money.
Calculating leverage ratios
An important aspect in using leverage is understanding how to calculate the ratio. The formula for leverage is:
L = A / E
where L is leverage, E is the margin amount (equity) and A is the asset amount.
So, dividing the asset amount by the margin amount gives the ratio of leverage.
It is also possible to start with the margin amount and apply a leverage ratio to determine the position size. In this instance the formula would be A = E.L. Therefore, multiplying the margin amount by the leverage ratio will give the asset size of a trader’s position.
Most traders distribute risks across different markets, meaning they are not putting all their eggs in one basket. This could be done by taking various positions in different markets. When this is the case, there may be the need to do calculations to determine things like net asset value, or the accumulative value of a trader’s positions. Thanks to platform technology that most brokers will offer, it is easier to monitor all parameters and open or close individual positions as needed. More importantly, it can help a trader work out if positions fit within their total leverage amounts, which should be less than the maximum leverage allowed by the broker.
Risk and leverage trading
The risk associated with leverage is the most crucial concept to comprehend in financial markets. Any sort of trading involves risk, but leverage can increase both profits and losses. Trading professionals would be wise to take special care when deciding how much leverage to utilize. Prior to trading, the leverage ratio should be established. If you have a run of profitable trades, it might be very tempting to trade in a larger size than what was originally planned.
If a trader decides to take a one-off risk and wins the transaction, they may benefit from doing so. But if it's done incorrectly, a trader risking a considerably greater loss than usual. To help reduce risks in trading, you should plan out your trading strategy in advance.
How much risk to take on each trade and how much risk to take on each day could be considered when deciding how much leverage to apply to a portfolio. It is simpler to examine this in terms of percentages. A trader can first choose how much risk they are ready to face daily. This entails determining the most money a trader is willing to lose in a single trading day. For instance, it might fall between 1% and 2%. If a trader uses 2% as their daily maximum risk, it will take 50 days of consistently losing transactions for them to lose all their cash, which is a scenario that should be exceedingly uncommon.
The number of deals a trader wants to execute each day should also be decided. This value may be a minimum or a maximum. For instance, a trader might decide to make three trades every day regardless of the market. Or they will only execute three trades each day at most. The trader can in each scenario split this number by the percentage they are willing to risk each day.
Source: CMC Markets UK
Disclaimer: Century Financial Consultancy LLC (“CFC”) is Limited Liability Company incorporated under the Laws of UAE and is duly licensed and regulated by the Emirates Securities and Commodities Authority of UAE (SCA). This document is a marketing material and is for informational purposes only and must not be construed to be an advice to invest or otherwise in any investment or financial product. CFC does not guarantee as to adequacy, accuracy, completeness or reliability of any information or data contained herein and under no circumstances whatsoever none of such information or data be construed as an advice or trading strategy or recommendation to deal (Buy/Sell) in any investment or financial product. CFC is not responsible or liable for any result, gain or loss, based on this information, in whole or in part.
PLEASE READ THE FOLLOWING TERMS AND CONDITIONS OF ACCESS FOR THE PUBLICATION BEFORE THE USE THEREOF.
By use of the publication and continuing to access the publication, you accept these terms and conditions and undertake to be bound by the acceptance. CFC reserves the right to amend, remove, or add to the publication and Disclaimer at any time without any prior notice to you. Such modifications shall be effective immediately. Accordingly, please continue to review this Disclaimer whenever accessing, or using the publication. Your access of, and use of the publication, after modifications to the Disclaimer will constitute your acceptance of the terms and conditions of use of the publication, as modified. If, at any time, you do not wish to accept the content of this Disclaimer, you may not access, or use the publication. Any terms and conditions proposed by you which are in addition to or which conflict with this Disclaimer are expressly rejected by CFC and shall be of no force or effect.
No information as given herein by CFC in this publication should be construed as an offer, recommendation or solicitation to purchase or dispose of any securities/financial instruments/products or to enter in any transaction or adopt any hedging, trading or investment strategy. Neither this publication nor anything contained herein shall form the basis of any contract or commitment whatsoever. Distribution of this publication does not oblige CFC to enter into any transaction.
The content of this publication should not be considered legal, regulatory, credit, tax or accounting advice. Anyone proposing to rely on or use the information contained in the publication should independently verify and check the accuracy, completeness, reliability and suitability of the information and should obtain independent and specific advice from appropriate professionals or experts regarding information contained in this publication. CFC cannot be held responsible for the impact of any transactional costs or any taxes as may be applicable on transactions.
Information contained herein is based on various sources, including but not limited to public information, annual reports and statistical data that CFC considers reliable. However, CFC makes no representation or warranty as to the accuracy or completeness of any report or statistical data made in or in connection with this publication and accepts no responsibility whatsoever for any loss or damage caused by any act or omission taken as a result of the information contained in this publication. The articles does not take into account the investment objectives, financial situations and specific needs of recipients. The recipient of this publication must make its own independent decisions regarding whether this communication and any securities or financial instruments mentioned herein, is appropriate in the light of its existing portfolio holdings and/or investment needs.
This document is a marketing material and has been prepared by individual(s), marketing and/or research personnel of CFC. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is purely a marketing communication. In this publication, any opinions, news, research, analysis, prices, or other information constitute is a general market commentary, and do not constitute the opinion or advice of CFC or any form of personal or investment advice. CFC neither endorses nor guarantees offerings of third party, nor is CFC responsible for the content, veracity or opinions of third-party speakers, presenters, participants or providers. CFC will not accept liability for any loss or damage, including without limitation to, any loss of profit, which may arise directly or indirectly from use of or reliance on such information.
Charts, graphs and related data or information provided in this publication are intended to serve for illustrative purposes only. The information contained in this publication is prepared as of a particular date and time and will not reflect subsequent changes in the market or changes in any other factors relevant to their determination. All statements as to future matters are not guaranteed to be accurate. CFC expressly disclaims any obligation to update or revise any forward-looking statements to reflect new information, events or circumstances after the date of this publication or to reflect the occurrence of unanticipated events.
Staff members/employees of CFC may provide/present oral or written market commentary or analysis to you that reflect opinions that are contrary to the opinions expressed in this research and may contain insights and reports that are inconsistent with the views expressed in this publication. Neither CFC nor any of its affiliates, group companies, directors, employees, agents or representatives assume any liability nor shall they be made liable for any damages whether direct, indirect, special or consequential including loss of revenue or profits that may arise from or in connection with the use of the information provided in this publication.
Information or data provided by means in this publication may have many inherent limitations, like module errors or lack accuracy in its historical data. Data included in the publication may rely on models that do not reflect or take into account all potentially significant factors such as market risk, liquidity risk, credit risk etc.
The use of our information, products and services should be on your own due diligence and you agree that CFC is not liable for any failure to achieve desired return on investment that is in any manner related to availing of services or products of CFC and use of our information, products and services. You acknowledge and agree that past investment performance is not indicative of the future performance results of any investment and that the information contained herein is not to be used as an indication for the future performance of any investment activity.
This publication is being furnished to you solely for your information and neither it nor any part of it may be used, forwarded, disclosed, distributed or delivered to anyone else. You may not copy, reproduce, display, modify or create derivative works from any data or information contained in this publication.
Services offered by CFC include products that are traded on margin and can result in losses that exceed deposits. Before deciding to trade on margin products, you should consider your investment objectives, risk tolerance and your level of experience on these products. Trading with leverage carries significant risk of losses and as such margin products are not suitable for every investor and you should ensure that you understand the risks involved and should seek independent advice from professionals or experts if necessary.