Wikipedia – “Financial leverage – in finance, leverage is any technique involving the use of debt (borrowed funds) rather than fresh equity in the purchase of an asset, with the expectation that the after-tax profit to equity holders from the transaction will exceed the borrowing cost, frequently by several multiples — hence the provenance of the word from the effect of a lever in physics, a simple machine which amplifies the application of a comparatively small input force into a correspondingly greater output force. Normally, the lender (finance provider) will set a limit on how much risk it is prepared to take and will set a limit on how much leverage it will permit, and would require the acquired asset to be provided as collateral security for the loan. For example, for a residential property the finance provider may lend up to, say, 80% of the property’s market value, for a commercial property it may be 70%, while on shares it may lend up to, say, 60% or none at all on certain volatile shares.”
The leverage system is used by all CFD brokers , but its definition is often incomprehensible to new investors. In this article we will try to explain how the leverage used by trading platforms actually works.
The biggest advantage of leveraging CFDs is the fact that the investor needs much less equity than in the case of the classic stock exchange.
The amount of the leverage determines the degree by which the invested capital will be multiplied / or decreased, in the case of retail accounts the most commonly used leverage is 1:30 which covers most of the assets. This means that the invested amount will be multiplied / or decreased 30 times.
Some trading platforms offer professional accounts available to experienced users who meet certain requirements confirming their knowledge and investment skills. Accounts intended for professional users offer the possibility of using a much higher leverage, depending on the broker, it can reach up to 1: 500.
High leverage is not always the best solution because the risk associated with your investment increases proportionally to its level! The leverage system is based on crediting the investor by the broker, which allows him to invest with an amount much greater than he actually has.
However, he is not the real owner of the stocks, currencies, indices or commodities he is buying, as in the case of the classic stock exchange, but still earns / or loses the full amount when their prices change, as if he were the owner of the assets. The broker, on the other hand, profits from spreads, i.e. commissions charged for intermediation in concluding contracts, the amount of the spread depends on the broker and can be fixed or variable depending on the current price of the asset.
The best trading platforms offer a “margin” which should prevent investors from getting into debt, this is the% of the invested amount specified by the broker that secures the investment. After exceeding this level, the CFD contract is automatically closed, which should guarantee the user that the balance of his exchange account will not be negative (however, there are exceptions, more on this in the next article).
Leverage is a rather complicated process and it is easiest to explain using an example.
Consider the most popular EUR / USD currency pair:
The current selling rate of 1.10697 as at 20/11/2019
By investing EUR 100 in a EUR / USD contract for difference using a leverage of 1:30, our real capital will be multiplied 30 times, this means that we will receive a CFD contract for EUR 3000. Thanks to this, even small price fluctuations allow us to earn a large amount, assuming the scenario that the exchange rate rises by 2%, we would earn 60 EUR (3,000 EUR + 2% = 60 EUR) risking the loss of own capital of 100 EUR.
CFDs allow you to earn but also lose your capital , not only when the value of the selected asset increases, but also when its price decreases, because at the time of concluding them, the investor determines whether the price will increase or fall. If he thinks that the value will drop, he should choose the “sell” option, thanks to which he will earn when the price of the asset drops. If he chooses incorrectly – he will lose his invested capital.
Why does trading CFDs involve a lot of risk?
Because in the event of a mistake, the investor loses his money proportionally quickly what he earns, it means that if he made a wrong decision and in the above-mentioned example he would choose the sell option, i.e. he would conclude a contract for difference assuming that the EUR / USD exchange rate would fall, but unexpectedly for him the price would increase by + 2% it would lose EUR 60 of its real capital. Of course, only if he decides to close his contract at an unfavorable moment, he may, however, wait for the situation to change before ending his contract for difference, so as not to lose the money invested (we will clarify this in the next article).
If in the above example a leverage of 1: 300 (professional account) was used, then on the same exchange rate change + 2% the investor would earn EUR 600 by investing EUR 100 of his own capital (EUR 30,000 + 2% = EUR 600), however, in the event of a minor mistake, his contract would automatically close. It is enough for the EUR / USD exchange rate to drop by only 0.35% below the value it was at the time the contract was concluded. Why?
Because (EUR 30,000 – 0.35% = EUR 105) at this point the investor loses all his real investment capital, that is EUR 100, and the margin system “margin” closes the contract to avoid getting into debt. This is why more leverage does not always mean better earnings, because when you make a small mistake you can lose all your invested capital.
CFDs seem to be a better solution for many people than the classic exchange if we want to earn money but are not going to risk a large part of our own capital because in this system a small own contribution is enough.
However, it should be remembered that the higher the leverage, the greater the possible earnings, but also the greater possible losses . The solution to this issue is the method recommended by the best world-class investors, who advise to invest only a small part of the total capital, so that in the event of a loss, we will not be forced to change our lifestyle. It is assumed that 1/10 part of the capital is a safe threshold.
Leverage allows you to earn very quickly, but it can lead to losing money just as quickly. Beginner traders are recommended to start with learning the basic rules of the market on a free demo account, such accounts are shared by most brokers and differ from real ones only in the virtual currency, all charts, statistics and operation are the same as in the case of a real account. Thanks to them, you can test various investment strategies and choose the best one for you.