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.”
Leverage system is used by all CFD brokers, but its definition often remains incomprehensible to new investors. In this article we will try to explain how the financial leverage used by trading platforms actually works. The biggest advantage of CFD leverage is that the investor needs much less equity than a classic stock exchange. The amount of the leverage determines the degree by which the capital invested will be multiplied, for retail accounts the most common leverage is 1:30 covering most assets. This means that the invested amount will be multiplied 30 times, and the profit will be incomparably greater. 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. A high leverage is not always the best solution, because the risk associated with the investment increases in proportion to its level. The leverage system consists in crediting the investor with a broker, which enables him to invest a much larger amount than he actually has. However, he is not the real owner of the shares, currencies, indices or commodities bought, as in the case of the classic exchange, but he still earns the full amount if he changes their prices, as if he were the owner of these assets. The broker, on the other hand, gains profits from the spreads, i.e. the commission charged for brokering contracts, the amount of the spread depends on the broker and can be fixed or variable depending on the current asset price.
The best trading platforms offer a “margin” or margin that prevents investors from getting into debt, this is determined by the broker% of the invested amount that secures the investment. After exceeding this level, the CFD contract is automatically closed, which guarantees the user that his account status will never be negative. By investing in differential contracts through brokers distinguished by us in the ranking, there is no way to get into debt. We can lose up to as much as we decide to pay to our broker’s trading account, because each of them guarantees its clients a security deposit.
The financial leverage system is a rather complicated process, it will be easiest to explain using an example.
Consider the most popular EUR currency pair / USD:
Current selling rate of 1.10697 as at November 20, 2020
By investing 100 EURO in a EUR / USD differential contract using a leverage of 1:30, our real capital will be multiplied 30 times, which means we will receive a CFD contract for EUR 3,000. Thanks to this, even small price fluctuations allow us to earn a large amount, assuming a scenario that the rate increases by 2%, we would earn 60 EURO (3000 EUR + 2% = 60 EUR) while risking our own capital of 100 EUR. CFDs allow you to earn money not only in the event of an increase in the value of the selected asset, but also when its price drops, because at the time of their conclusion the investor determines whether according to his predictions the price will rise or fall. If he thinks that the value will fall, he should choose the “sell” option, thanks to which he will earn at the moment when the price of the asset falls.
Why investing CFDs involves 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 the wrong decision and in the above-mentioned example he would choose the option to sell, i.e. would enter into a differential contract assuming that the EUR / USD exchange rate would fall, but unexpectedly for him the price would increase by + 2%, he would lose 60 EUR of his real capital. Of course, only if he decides to close his contract at an unfavorable moment, but he can wait for the situation to change before he finishes his differential contract, so as not to lose his invested money.
If 1: 300 leverage (professional account) were used in the example above the same exchange rate change + 2%, the investor would earn 600 EUR by investing 100 EUR own capital (30,000 EUR + 2% = 600) EUR), but in the event of a small mistake his contract would be automatically closed. It is enough for the EUR / USD exchange rate to fall by just 0.35% below the value 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, ie EUR 100, and the margin system “margin” closes the contract to prevent debt. It is for this reason that greater leverage does not always mean better earnings, because in the event of a small mistake you can lose all the capital invested.
Contract CFD for many people can be a much better solution than the classic stock market, if we want to earn good money, but we 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 higher the earnings, but also the increased the risk. The solution to this issue is the method recommended by the best world-class investors who advise you to invest only a small part of all your capital, so that in the event of a loss you will not be forced to change your lifestyle. It is assumed that the safe threshold is 1/10 part of the capital held. Leverage allows you to earn very quickly, but it can lead to equally fast loss of money. However, despite the risk, it is an interesting way to multiply capital and certainly the chances of successful investments increase proportionally to the development of our knowledge of market principles and the experience we gain. Beginner traders recommend starting with learning the basic principles of the market on a free demo account, these accounts are offered by many brokers and differ from real ones only with virtual currency, all charts, statistics and operations are identical to real accounts. Thanks to them you can test various investment strategies without risk and choose the best one for you.
If you’re wondering which broker to choose, you can find a comparison of the most popular platforms that allow you to trade differential contracts in the Broker Ranking prepared by a team of our experienced investors.