Leverage can be a valuable tool in your trading operations, and can be used to help you make the most of an unfavourable or unprofitable situation. But what exactly is leverage, and how can you best use it when trading? Read on to find out more.
What is leverage?
The clue is in the name. Just as a mechanical lever helps you move a heavy load with only a small amount of force, leverage (also known as gearing or geared trading in some countries, such as the UK and Australia) enables you to gain a large exposure to a financial asset using only a small amount of your trading capital.
When you buy an asset in the traditional way, you generally need to pay the full purchase price up front: the total value of the shares, currency, barrels of oil or whatever you’re trading. However, some providers offer the facility to trade using leverage, which means you only have to put up a fraction of the value of your position. Effectively, your provider lends you the rest of the purchase price.
This means that any profit you make, which is still based on the full value of the position, appears magnified in comparison to your outlay. This can particularly help in markets that are less volatile, as it enables you to capitalise on smaller movements in price. The flip side of this is that any losses are magnified in the same way. With leverage, both your profit and any loss can actually exceed your initial outlay.
How does leverage work?
Let’s have a look at an example to illustrate how leverage works.
Suppose you decide to buy 1000 shares in Tech Giant Inc. The share price is $1, so to open a conventional trade with a stockbroker you pay 1000 x $1 = $1000. (We’ll ignore any commission or other charges to keep this example simple.)
Alternatively, you could decide to trade using a provider that offers leverage facilities. The provider will ask you to pay just a percentage of the full $1000 to open your trade. This is known as a margin or deposit requirement, and the actual percentage will vary from asset to asset, and from provider to provider.
Say your provider has set the margin requirement for Tech Giant Inc at 10%. This means you need to pay only 10% x $1000 = $100 to open your position. You still have exposure to 1000 shares, but at a tenth of the initial cost.
Ways of trading with leverage
A wide range of leveraged trading products are available, covering almost every conceivable market, and many providers offer at least some degree of leverage on trades.
Most leveraged trading is done through derivative products; these are financial instruments that derive their value from an underlying asset. With a derivative contract you never own the underlying asset directly, but you have a financial interest in its performance.
Here are the main ways you can choose to trade with leverage:
- Spread betting (UK only): Financial spread betting providers enable you to place a bet on the direction a market will take, rather than trading the market directly.
- Contracts for difference (CFDs): a CFD is an agreement to exchange the difference in value of a particular asset from the time at which the position is opened to the time at which it is closed. To find out more about CFDs, you can check out our blog post here.
- Forex trading: you can speculate on the future value of one currency compared to another via a forex broker. To find out more about forex trading, you can check out our blog post here.
- Futures: a futures contract is an agreement to buy or sell an asset at some time in the future for a particular, specified price.
- Options: options are contracts that give you the right, but not the obligation, to buy or sell an underlying asset at a fixed price on or before a certain date.
The costs of using leverage
To keep things simple, in the examples above we’ve ignored any charges and commissions that you might pay as part of the normal trading process. It’s worth mentioning one cost that you could sometimes see when using leverage, though.
Since you don’t put up the full value of your position when you trade with leverage, this means your trading provider is effectively lending you the balance of the money. For this reason, they may make a small charge to reflect their costs when you keep a trade open overnight. This is called an overnight funding charge. It varies between different products and providers, so keep an eye out for it in terms and conditions.
As we’ve discussed, to open a leveraged trade you need only deposit a fraction of its full value, but your losses can exceed this amount. This means that, if a position moves against you, your provider may ask you to provide additional funds to keep your trade running.
These payments are properly known as ‘variation margin’, although people usually just refer to them as ‘margin’. A request for variation margin is called a margin call.
For example, say you buy 8000 shares at 220p using leverage. The value of your position is therefore £17,600. The provider asks for an initial margin payment of 5%, which is £880.
The share price then drops by 1p to 219p, reducing the value of your position to £17,520. The margin requirement falls to 5% x £17,520 = £876 as a result.
However, although the initial margin requirement has reduced, you now have a running loss of 1p x 8000 = £80.00 to add to this, bringing the total required to keep your position open to £956.
Unless you’re already holding sufficient funds in your account to cover this, your provider will ask you to make a margin payment. If you don’t do so promptly, they may scale back or even close your position completely.
Dividend payments on short positions and funding costs are other factors that may sometimes put your account into deficit, requiring you to deposit more money. It’s wise to remember that the initial cost of opening a position isn’t the end of the story – you may need to have more funds available to top up your account as you go.
When to use leverage
We’ve seen that trading with leverage gives you comparatively greater profits – but also relatively larger losses. Does that make it riskier than conventional trading?
From one perspective, yes. If you commit yourself to a leveraged trade based on the affordability of the initial margin, rather than your capacity to withstand the potential losses, you’re undoubtedly playing with fire.
However, as long as you think of every position in terms of its full value and downside potential, the risk is no greater than it would be when trading directly. Your eventual profit or loss is the same – it’s only the outlay to produce it that differs.
There are also a number of steps you can take to manage the risks of trading. If you want to find out more about these steps, you can check out our blog post on money management here, as well as our other blog posts on risk management here.
So, provided you understand how leveraged trading works, it can be a very useful tool; there’s no need to tie up a large amount of your trading capital on one trade, and you can deal on expensive assets at a fraction of the cost. Used sensibly, leverage can make trading easier and more convenient.