Leverage trading
Leverage is the use of a smaller amount of capital to gain exposure to larger trading positions. A leverage of 10:1 means that in order to open and maintain a position, the necessary margin required is one tenth less than the transaction size. So, a trader would require £10,000 to 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. So, if a trader wanted to make a £10,000 trade on a financial asset that had a leverage of 10:1, the margin requirement would be £1,000.
Leverage is used across a variety of financial markets, including forex, indices and stocks. Of course, some markets are more volatile than others. This means that leverage may be limited to smaller multiples of capital. Leverage rates can also vary depending what type of trader you are, either retail of professional. While retail leverage rates for forex are around 30:1, they are around 500:1 for professional clients. While professional clients can access higher leverage rates, they must meet strict criteria in order to be eligible.
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.
What is leverage in trading?
So, what does leverage mean? Understanding margin and leverage and the difference between the two can sometimes cause confusion. It is important to realise that margin is the amount of capital that is required to open a trade. Leverage is the ratio applied to the margin amount to establish how big a trade is going to be placed.
Leveraged trading is more likely to be adopted by those trading short-term price movements. It would be much less suitable to anyone investing long-term, for example over multiple years or even decades. In this instance, a ‘buy and hold’ approach would be more suitable. Leveraged trading is more likely to be adopted by those trading short-term price movements. It would be much less suitable to anyone investing long-term, for example over multiple years or even decades. In this instance, a ‘buy and hold’ approach would be more suitable. It is important for all traders to bear in mind the risks involved in leveraged trading. Many traders see their margin wiped out incredibly quickly because of a leverage that is too high. Novice traders should be especially careful when trading on margin. It is best to be more prudent and use a lower leverage. A lower leverage means traders are less likely to wipe out all of their capital if they make mistakes.
How does leverage trading work?
It is advisable that a trader starts with a leverage that is lower than their maximum leverage allowance. This enables traders to keep their positions open for the full size, even if they are experiencing negative returns.
Leverage example
For example, let’s say a trader has a maximum leverage of 10:1 and opens a position with that leverage on a $10,000 account. The trader now has a position size with an asset value of $100,000. This means a price movement of 1% will wipe out the position completely. Also consider that if the position is losing $5,000, the broker may reduce the trader’s position. This is because the trader now only has $5,000 of available capital, and 10:1 leverage means his maximum position allowed should be $50,000 not $100,000.
Reducing the leverage to 5:1 with an initial outlay of $10,000 will mean that the position is now $50,000, and a 1% move will be equal to $500. Keeping leverage rates low means that if the trader does lose money, it is less likely to wipe out all or a substantial amount of their capital.
What are leveraged products?
Leveraged products are derivative instruments that are worth more on the market than the deposit that was initially placed by an investor. The two significant leveraged products that we offer are spread betting and contracts for difference (CFDs). When trading with leverage on either of these products, an investor can place a bet using a reasonably small margin on which way their chosen market will move. The investor technically does not own the underlying asset, but their profits or losses will correlate with the performance of the market.
The key difference between spread betting and CFD trading is that the former is exempt from capital gains tax (CGT), while the latter requires you to pay this tax. CFD traders will also have to pay a commission charge in addition to the spread when trading shares. To calculate your profits or losses, you must find the difference between the price at which you entered and the price at which you exited. For spread betting, this figure should then be multiplied by the stake, and for CFDs, it should be multiplied by the number of CFD units. Both are at risk of financial loss, but equally, financial gain if the market moves in a favourable direction. Spread betting is only available to customers residing in the UK or Ireland, whereas CFDs can be used globally. Read more about our CFD commission rates here, along with our article on CFD meaning.
Leverage ratios in the financial markets
Leverage currency trading
Forex trading is the buying and selling of foreign currencies across the global market. Forex leverage ratios start relatively high compared to other markets at around 30:1, meaning that there is a high opportunity for profit or loss, depending on how you look at it. However, this can also depend on the type of trader, whether retail or professional, as professional traders are able to use a much higher leverage of up to 500:1.
Indices
Indices represent the overall price performance of a group of assets from a particular exchange. Commonly traded indices include the FTSE 100, S&P 500 and the Dow Jones 30. Indices tend to have quite low margin rates and therefore high leverage ratios of approximately 20:1.
Leveraged share trading
Another market with a relatively low leverage ratio is share trading, where we offer spread betting and CFD trading prices on more than 9000 international shares and ETFs within the stock market. Leverage ratios starts from 5:1 and apply to all countries.
Cryptocurrency leverage trading
Bitcoin, ethereum and litecoin are all well-known cryptocurrencies across the globe. Cryptocurrencies are particularly volatile and can drop at any point; therefore, investors are advised to take caution when using leverage as part of their trading strategy, as this could lead to significant losses. Our average leverage ratio for trading cryptocurrencies starts at 2:1, which is much lower than other financial markets, due to the substantial risks.
Leverage ratio formula
An important aspect in using leverage is understanding how to calculate the ratio. The following leverage ratio formula is commonly used and easy to remember:
L = A / E
where L is leverage, E is the margin amount (equity) and A is the asset amount.
Therefore, dividing the asset amount by the margin amount gives the ratio of leverage.
How do you calculate leverage ratios?
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 capital into one trade. This is done by opening various positions in different markets. When this is the case, there may be the need to do calculations to determine 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.
Leverage trading platform
As discussed, we have differing leverage ratios and margin rates for each type of financial market and asset. All products are available on our award-winning trading platform, Next Generation, where you can put into place risk management tools, such as stop-loss and take profit orders. Familiarise yourself with our platform now by creating a live account, or practise first with virtual funds on a demo account, which is included for free upon registering. Take a look at our extensive list of charting features here.
Spread betting leverage
Spread betting is the most popular product on our platform, which you can use to trade an endless array of financial assets. As discussed, you must use leverage when spread betting our products, which can bring risks. This is why we offer you the chance to familiarise yourself with the platform on our demo account before depositing real funds. Below, we explore the risks of spread betting leverage in more detail.
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Risks of leverage
The most important thing to understand when talking about leverage is the risk involved. Risk is inherent to any type of trading, however, leverage can cause both magnified profits and losses. It would be prudent for traders to pay particular attention to choosing how much leverage they will use. The leverage ratio should be determined in advance of trading. It is very tempting to trade in a larger size than what was originally determined if you have a streak of winning trades.
Doubling your risk on a one-off basis could benefit a trader if they happen to get that one-off trade right. But get it wrong and a trader could end up facing a much larger loss than usual. To help reduce risks in trading, you should plan out your trading strategy in advance.
Two factors could be taken into consideration when determining what amount of leverage to apply to a portfolio: how much risk to take per trade and how much risk to take per day. Examining this via percentages makes things easier. First, a trader can determine how much risk they are willing to take per day. This involves deciding the maximum amount that you are willing to lose. This could, for instance, be between 1% and 2%. If a trader were using 2% as maximum daily risk, it would take 50 days of bad losing trades in a row to wipe out their capital, which is hopefully extremely unlikely to happen.
A trader should also determine how many trades they want to place per day. This could be a set number or a maximum number. For example, a trader may decide that whatever the market, they will make a maximum of three trades a day. In each case, the trader can divide the percentage they are willing to risk per day by this number.
Leverage risk management
A popular risk-management tool to be considered when trading with leverage is a stop loss. By implementing a stop loss order to your position, you can limit your losses if your chosen market moves in an unfavourable direction. For example, a trader may choose a pre-determined figure that they do not want to surpass, meaning that your stake in the instrument will be sold at the given price. However, please note that basic stop losses are susceptible to market gapping and slippage. Guaranteed stop losses work exactly in the same way as basic stop orders, although investors can choose to pay a small fee to guarantee the closing of a trade at the exact price specified. This way, if you have used a particularly high leverage in the trade, there will be less chance of multiplying your losses, regardless of market volatility.
Read more about how to protect your money in trading with our risk management guide.
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Disclaimer: CMC Markets is an execution-only service provider. The material (whether or not it states any opinions) is for general information purposes only, and does not take into account your personal circumstances or objectives. Nothing in this material is (or should be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by CMC Markets or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person.