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What is leverage?

Posted By Robert On Monday, January 20th, 2014 With 0 Comments

Leverage is the effect of gaining a large exposure to a market with a fraction of the money on deposit. The leverage factor is the multiple used to calculate the trade value as a proportion of the margin required to execute a trading position. On some brokers you can use a leverage of 5:1, 10:1, 20:1, 30:1, 40:1 or 50:1. For example, if you are using a rate of 20:1, this means that you can trade a position twenty times larger than your margin. And your potential gains or losses will be amplified by this ratio. A small change in the underlying price can cause the loss of some or all of your investment.

Let me explain to the unwitting public that leveraged instruments can be dangerous in the hands of the unwary, the downside of these can have your health, wealth and sanity at risk. Be conservative with leverage.   If you are leveraged to the tilt and a position turns against you, you will lose your leveraged $$$ quicker than Hussain Bolt.

Spread Betting and CFDs

Note that spread betting and CFDs are leveraged trading products; you are in effect borrowing money from your broker to take on larger positions that you could otherwise afford.

Let’s take stock in a transport company called Swift Transport, which say, are trading at about £1 each. With normal shares dealing, if you want to own £1,000 of the company’s stock, you need to buy 1,000 of them and pay the full amount when buying the shares.

On a spreadbet, you would just place a bet of £10 per point for the equivalent exposure. So if Swift Transport shares were to rise by a penny (equating to a point) – you would win £10, just as on the share trade.

The difference with the spreadbet is that you would only need to deposit a fraction of the £1,000 to open this trade. So, for instance, opening a £10 per point spread bet on Swift Transport may require an initial deposit of £100 (at a 10% deposit rate), as opposed to the £1,000 upfront if you had bought the shares.

This allows clients to open larger positions than might otherwise be possible but be warned – this can work both ways. If Swift Transport shares go up by 20p, you have risked £100 to win £200 (20 points x £10). But the reverse is also true. If the shares lose 20p, you will have lost £200 – twice your stake.

Do I have to trade with a margin?

Most providers offer margined trading and do not provide a facility to fully fund your CFD positions. Trading on margin will amplify your potential trading losses or gains. Except Ayondo which I believe permit you to use as much (or as little) leverage as you like!

As Warren Buffett once said: ‘Leverage is one of those things that works 99 times out of 100, and when it doesn’t, you know, it’s all over.’

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