Trading strategies are designed to help individuals become more successful investors. Leverage is a type of trading strategy that involves being able to own a larger holding of assets than you’ve actually paid for.
Here, Telegraph Money explains how leverage in trading works, and outlines the risks and benefits.
Also known as margin trading, leverage trading works on the idea that you can use a smaller amount of money to gain exposure to larger trading positions.
It means you can gain greater exposure to a market while putting up only a fraction of the full trade value. You could enhance your position size by five, 10, 20 or even 33 times the amount of your initial outlay.
You can do this across a variety of financial markets, such as stocks, exchange-traded funds (ETFs), foreign exchange (forex), indices, commodities and some government fixed income.
Your total profit or loss will be calculated on the full position size, not your margin amount.
So, if you paid £200 to open a position worth £1,000 with a company whose shares were priced at 100p, your margin would be 20pc.
If the company’s share price rises by 40p, your 1,000 shares are now worth 140p each – a £400 profit. Yet, if the share price dropped by 40p, you’d have made a £400 loss – double your initial amount paid.
Leverage and margin are related in that they are both involved in allowing investors to use borrowed money to invest and hopefully enhance profits.
Leverage is the amount that your capital is magnified by, expressed as a ratio. Margin is the money from the investor used to gain the enhanced exposure to a chosen asset.
When one increases, the other decreases by the same.
For example, if the leverage ratio is 20:1, the margin factor is 20pc. This means that the investor needs to deposit 20pc of the total investment value to open the trade.
Any financial product that allows you to take a position that is worth more on the market than your initial outlay is a leveraged one.
The main leveraged products include:
There is no right or wrong amount of leverage. It all depends on your appetite for risk.
Remember, losses – and gains – are calculated on the full size of the position, not your initial outlay so you need to be comfortable with a potential and magnified loss.
If you’re at the more cautious end of the scale then perhaps a lower level of leverage like 5:1 or 10:1 might be suitable. If you’re at the more adventurous end of the scale you will likely want to go much higher.
However, the sky isn’t the limit for all assets. For retail investors (in other words, ordinary investors), City watchdog, the Financial Conduct Authority (FCA), limits leverage to 30:1 for major currency pairs, for example. Equally, some brokers might choose an upper limit to restrict exposure to risky markets.
Leverage requires borrowing – and this loaned money must be repaid. In leverage trading, you’re required to maintain a certain amount of money (initial margin) in your broker trading account to cover potential losses.
If your account falls below the required margin – perhaps if you suffer a string of losses – you will face what is referred to as a “margin call”, where you’re asked to fund the account to make up the difference. During this time you won’t be able to open any new positions – you will only be able to close existing ones.
Some brokers might simply close your positions before your balance goes negative to avoid investors falling below that minimum requirement.
Beginners might want to start with low leverage to help them to limit losses and manage risk easily. Broadly speaking, a good rule of thumb is to begin with a low leverage of, say, 1:10.
You can get used to the strategy and how it works and build up to higher and more risky levels as you progress in time.
2024-11-22T16:03:56Z