Leverage is both the joy and scourge of traders in equal measure, and can single-handedly make or break your trading success. For the most part, millionaire traders have got there as a result of leverage, and without this often invaluable tool they would probably still be toiling to build up their trading capital and, bluntly, nowhere near as successful. Indeed, many of today’s most popular trading forms, such as spread betting and CFD trading rely on leverage to a massive extent, and attract new aspiring traders in their tens of thousands each year. But what exactly is leverage, how does it work, and what role can leverage play in your trading activities?
What Is Financial Leverage?
Leverage is essentially loan finance permitted on a given transaction to allow a trader to ‘gear up’ his exposure, without having to invest 100% of the trade value. The broker usually allows a trader to open a position at a much higher value than his current trading account balance, often requiring as little as 5% in margin deposit to allow an individual transaction to proceed. In effect, this allows the trader to earn off the back of 100% of a transaction, at a personal up-front cost of just 5%, (or whatever the agreed margin rate may be).
However, while leverage can have a dramatically positive effect on your trading, it nevertheless presents a range of risks and dangers, and is all too often the ruin of even experienced traders. Leverage can work both for you and against you in equal measure, and the higher earnings of leverage wouldn’t be possible without a corresponding leveraged risk profile.
Financing Costs and Margins with CFDs
In addition to paying financing costs, a negative leveraged position must be paid up, and will solicit the margin call to the extent that your account is unable to pay. For this crucial reason, respecting the threats posed by leverage and monitoring your risk exposure throughout your trading activity is an essential strategy to mitigating losses on wayward trades.
CFDs themselves are margined products, and more often than not are traded with the benefit of leverage, supplied by the broker to the trader to finance particular trades. Just like any other form of loan finance, leverage attracts financing costs in the form of interest, which takes account of the risk of default and builds in a profit margin for the broker in respect of the service (i.e. the leverage) offered.
This obviously makes for a factor that must be considered in attempting to calculate the whether or not a position is likely to yield a profit, and spiralling costs of leverage finance can at times make certain positions unviable.
Leverage can be a double-edged sword, and has the effect of amplifying trading positions across the board to maximise earnings and, unfortunately, losses. As a trader, it’s not advisable to stay clear of leveraging positions if you’re looking to build your portfolio quickly, but it is important to remember to give due consideration to the risks and the pitfalls associated with leveraged trading, to make sure you don’t become another trading statistic.
Why It’s Important To Be Careful Trading CFDs
When it comes to successful trading, caution is a necessary virtue for the preservation of capital, and in ensuring you take decisions in the best interests of your wider portfolio. Having discussed the disadvantages of leverage and the potentially disastrous effect of calling it wrong when trading margined products, it’s important to stress the value of caution in adopting leveraged positions, to ensure the levels of risk involved are given sufficient consideration and weight before it’s too late.
Leverage plays an inherent role in the appeal of CFD trading, and it is a central component to the idea of trading contracts for difference. Because CFDs are traded on margins, traders find themselves embracing leverage as a part of their CFD trading, and should ensure that their exposure is kept within reasonable boundaries at all times to avoid bearing the brunt of leveraged losses. As a result, CFD traders in particular need to take steps to hedge their positions, and set controlled stop losses to prevent undue liability for unfavourable positions.
Unfortunately, there are countless traders of all levels of experience and success that have lost out as a result of careless or risk-averse trading on margined, highly leveraged products. Indeed, much of the last global banking crisis could be attributed to poor risk management, and to avoid a similar fate in your personal trading its important to take care in the positions you open and the level of risk and leverage you’re prepared to take on board.
Impact of Leverage
Make sure you understand the impact of any leverage on a particular trade before you commit to opening your position. Calculate your potential losses (including any stops you may have in place), and add these to the costs of entering the position – is it feasible that you will be able to recoup these costs, or are you hoping for significant market movements to cover these expenses?
Furthermore, CFD traders can often run into difficulties by failing to take account of the larger costs associated with leveraged transactions. Firstly, transaction commissions are usually payable on the total transaction amount – i.e. not just the margin requirement for a particular trade. This translates into transaction costs that are relatively high compared with pound-for-pound trading.
In addition to the broker commissions, your leverage will give rise to an interest charge, to be paid from any profits your position ultimately takes.
Interest is obviously payable relative to the duration of the leveraged position, with longer-term overnight positions attracting higher interest costs than shorter-term trades. As part of the overall package of costs that go hand in hand with leverage, interest is an important factor to include in any individual profit calculation, to make sure the position you’ve taken is one that could logically yield a satisfactory profit.
Leverage and CFD trading go hand in hand, and it’s important not to be too scared of applying leverage to your transactions as and when necessary.
However, being sure of the risks and the potential pitfalls associated with a leveraged trade goes someway to ensuring that your trading is kept within manageable boundaries, and that you’re prepared to meet your obligations in respect of any losses and margin calls that may be forthcoming in the aftermath of a rogue trade.
