What is Leverage?
Leverage is a financial tool that enables traders to control a large position with a relatively small initial investment. Unlike traditional investing, where you pay the full value of an asset upfront, leveraged trading requires only a deposit—known as margin.
For example, with a 20:1 leverage ratio, €1 of your capital allows you to manage a €20 position. This accessibility broadens opportunities in markets such as forex, indices, and commodities for retail traders who may lack substantial funds. However, leverage intensifies both profits and losses, requiring careful handling to mitigate its inherent risks.
What is Margin?
Margin is the funds you commit to open a leveraged trade—essentially your entry fee. The amount varies by market: trading shares might demand 25% of the position’s value, while forex could require as little as 2%.
CFDs, a widely used leveraged instrument, allow speculation on price movements of assets like stocks, currencies, or indices without ownership. To illustrate, let’s compare traditional and leveraged approaches.
Comparing Traditional Investing and Leveraged CFDs
Traditional Investing: Buying Shares
You acquire 50 shares of ABC Corp at €20 each.
- Total value: €1,000.
- No leverage means you pay €1,000 in full upfront.
Profit Case:
ABC’s price rises 10% to €22. Your shares are now worth €1,100, yielding a €100 profit—a 10% return on your €1,000 investment, steady and predictable.
Loss Case:
A 10% drop to €18 reduces your shares to €900, resulting in a €100 loss—also a 10% decline, balanced but limited.
Leveraged CFDs: Amplifying Exposure
You trade CFDs worth €1,000 (50 shares at €20 each), with a 20% margin requirement.
- Position value: €1,000.
- Margin required: €200 (20% of €1,000).
Profit Case:
The price increases 10% to €22, raising your position to €1,100. Closing delivers a €100 gain—a 50% return on your €200 margin, five times the traditional outcome.
Loss Case:
A 10% fall to €18 lowers your position to €900, incurring a €100 loss—a 50% reduction of your €200 margin, far exceeding the 10% unleveraged impact.
This comparison underscores leverage’s ability to magnify results. While profits can soar, losses escalate just as quickly, making risk management tools like stop-loss orders critical.
What is a Margin Call?
A margin call is a broker’s alert that your account’s equity—the sum of your deposited funds adjusted for profits or losses—has fallen below the minimum required to sustain open positions. Per industry standards, this typically occurs when equity dips below 100% of your margin requirement, signaling potential closure unless addressed.
In our CFD example, your €200 margin supports the €1,000 position. If ABC’s price drops to €19.50, your position becomes €975, with a €25 loss, leaving €175 in equity (assuming a €200 starting balance). A broker requiring 100% (€200) might issue a margin call here, often notifying you via email when equity nears 75% (€150) to prompt action.
You can respond by:
- Adding Funds: Deposit €50 to lift equity above €200, stabilizing your position.
- Reducing Exposure: Sell 25 shares, cutting your position to €487.5 and margin to €87.5, freeing up equity.
- Closing the Trade: Exit entirely, accepting the loss but preserving remaining funds.
If losses deepen—say, the price hits €18 (€900 position, €100 loss)—your equity falls to €100. Should it breach 50% of the margin requirement (€100), brokers often auto-close positions to limit further risk, a safeguard to prevent unpayable debts. This threshold varies, but it’s a critical line: cross it, and your trade ends automatically.
Costs of Leverage
Leveraged trading involves fees, primarily in two forms:
- Spreads or Commissions: Opening a trade incurs a cost—either embedded in the spread (the buy-sell price difference) or charged separately as a commission.
- Overnight Financing: Positions held beyond a day incur a fee, known as overnight financing, to cover the borrowed capital. This is typically a small percentage, applied daily for ongoing trades or built into the spread for forwards.
Conclusion
Leverage offers a pathway to enhanced trading possibilities, allowing you to maximize limited capital. Yet, its amplifying effect demands diligence—understanding margin, monitoring equity, and employing robust risk strategies are vital to harnessing its benefits while avoiding pitfalls. Ready to test your knowledge? Join Hoorah's 3 Step Challenge today!