Dangers and Disadvantages of Leverage

Posted By Robert On Thursday, May 19th, 2016 With 0 Comments

Although leverage is a massive attraction for many and is seen to be an easy way for CFD traders to make exponential profits it must be used with caution.  It is by no means a guaranteed way to make huge sums of money although when put in the right hands, it can be an excellent tool to have in your armoury.

What risk does leverage pose?

When you trade on leverage, you are taking positions that are worth considerably more than the money you initially put up front.  This allows you to make larger gains but people often underestimate the losses that can be made.  When overexposed, all it takes is for a quick shift in the markets for you to be in negative territory, lose all of your capital or even to be heavily in debt to the CFD broker.  LOSSES ARE NOT LIMITED TO YOUR TRADING BALANCE.

An example:

Harry opens an oil contract worth the equivalent of £20,000 with a margin requirement of just 5%.  On this basis, he is only required to have £1000 in his trading account.  If the value of his position falls by 15% to £17,000, he will be liable for the £3000 loss, even if he only has £1000 in his account.

Although it is likely the broker will have automatically closed him out early, when markets are turbulent, it isn’t always possible for them to do so.

In this instance, Harry will have to repay the CFD broker the £2000 shortfall or risk further action like having a default on his credit record.

Interest Charges and Fees

Any leveraged trade incurs higher costs than an unleveraged purchase.  When a trader goes long on leverage they are essentially borrowing money from the CFD broker and are required to pay interest on this.  The larger the amount of leverage in the trade, the more interest they will incur.  In addition, the more leverage included in the trade, the more commission the broker will charge to open the contract.

How to use leverage sensibly

To make the most of the benefits of leverage without suffering potentially huge losses, it is sensible to trade amounts that don’t leave the trader overexposed.  If the price of the asset moves against them, it would make sense to have funds to cover the movement to a pre-determined point.

It is also advisable to make use of the stop loss.  Whenever you buy financial assets through a Contract For Difference, you should consider how much money you are willing to risk in a worst case scenario.  If this is 10% of the contract’s value then simply setup the stop loss to close out your position if the asset’s price falls by this amount.

Hopefully the above hasn’t put you off too much as when used sensibly, leverage is an excellent feature of the CFD that can lead to gains that otherwise would be unattainable.  Good luck!

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