As a serious CFD or forex trader you will have to understand what leverage trading is and how to best use it to your advantage. In fact, leverage trading is such a fundamental part of spread betting that basic understanding of the concept is needed before you sign up with one of our recommended brokers.
Find the best trading platform. You capital is at risk when trading. Be careful.People who have heard about leverage and margin but aren’t completely familiar with the concept are usually either aware about the amazing benefits or the possibly treacherous risks that leverage can pose. Because of this, we’ll take a closer look at leverage trading, margin, and everything related to the subject.
What is Leverage?
Leverage is a concept that gives you the ability to enter trades that are bigger than the amount you physically invest by using credit. It’s a way to increase your potential profit from a certain investment, and it makes it possible to experience gains from speculating on even the smallest market movements. Essentially, leverage provides you with increased buying power.
One of the main reasons why you can use leverage today is because of the forex market. It can be hard to profit from exchange rates since they don’t tend to fluctuate that much. Even if you buy several thousand units of a certain currency pair, your daily profit from that investment can be minimal unless you’re using leverage. Leverage can help you increase your profit tenfold or even more, thus making an investment that would have otherwise been meaningless quite profitable.
A margin is a loan provided by your broker that helps create leverage. Depending on the asset you are trading, margin comes in different sizes from double the invested amount to several times higher than the funds in your account. In order to trade using leverage and margin, you need to open a margin account with a regulated broker. Just note that not all jurisdictions allow margin trading and that broker’s requirements for margin accounts differ quite a lot. To learn more about brokers that offer leverage trading we suggest you check out our recommended and fully regulated brokers.
Find the best trading platform. You capital is at risk when trading. Be careful.
How to Use Leverage
What exactly is leverage trading used for? In short, leverage trading helps you maximize your return on investment and it enables you to benefit from investing funds that you don’t have access to yourself.
When trading stocks with leverage, the margin is almost always 2:1, meaning the broker doubles your invested amount. If you invest $10,000 with a margin of 2:1 you can buy stocks for a value of $20,000. Other asset classes come with greater leverage and you could, for example, trade forex with 20:1 leverage, meaning the broker will lend you 20 times the invested amount.
We’ll try to further explain using an example.
You have found a company that you want to invest in. Stocks in the said company are currently selling for $100 each and you have access to 2:1 leverage. You have $10,000 dollars to invest so that will get you 100 stocks but since the broker provides you with an additional $10,000 it means you can buy 200 stocks for a total of $20,000. Two weeks later the stock has increased by 30% and is now selling for $130 dollar per stock. That means your investment is now worth a total of $26,000 so you decide to close your position and sell the stocks. Before you can cash out, the broker will reclaim their $10,000 leaving you with $16,000 and a profit of $6,000. Technically, you’ve maximized your return on investment by making a 60% profit from a 30% price increase. Without leverage, you would have only made $3,000 in profit for the same trade.
Note that leverage rarely comes free of charge and that brokers always takes out a fee for handling your trades – some brokers even take out interest on margin. Because of this, you won’t actually be able to pocket the full $6,000. Always check the terms before you start investing so that you don’t get a surprise when trying to cash out.
Margin Accounts and Regulation
In order to be able to trade using leverage you first need to open a margin account with a broker. Depending on the broker and the asset you want to invest in, the available margin will differ. It’s not uncommon for CFD and forex brokers to require you to take a quick test in order to evaluate your understanding of margin and leverage. The results of your test are then used to set limits for the available leverage based on your knowledge.
Before 2010, one could trade forex using leverage of up to 100:1 but to due to the potential risk, maximum leverage was lowered to 50:1. Then in early 2018, the European legislation for leveraged CFD trading was updated again. Today, the maximum amount of leverage for different asset classes is as follows.
- Major currency pairs such as USD/EUR can be traded with leverage of 30:1
- Mid-range currencies, gold, and major indices can be traded with leverage of 20:1
- Exotic currencies, indices, and all other commodities can be traded with leverage of 10:1
- Stocks as CFDs and all other underlying assets can be traded with 5:1 in leverage
- Cryptocurrencies have been limited to 2:1
Note that these are the maximum levels and that a broker can decide to limit the leverage further.
Risks With Leverage and How to Avoid It
Before you start trading with leverage you need to be aware of the risks. You see, there are two sides to leverage trading. As mentioned, you can maximize profit and make large gains from smaller investments using margin and leverage. On the other hand, you increase the potential loss and risk for each trade. Because of this you always need to have an active protection plan that will help you minimize the risk you put yourself in.
Just like your profit can increase if the value of an underlying asset moves in the direction you’ve predicted, your losses will be amplified if the asset moves in the wrong direction. For example, if you invest in a stock using margin and that stock falls in value, you will end up losing money you’ve invested as well as money that the broker invested, and at the same time, you have to pay the broker back for the margin. This is the reason why limits have been put on leverage (see above) and why certain countries have decided to completely ban leverage trading.
That being said, there are ways one can limit some of the risk involved in leverage trading. First and foremost, you should never invest if you’re not confident that the investment will bring you profit and you should never trade using margin unless you’re sure of how it works. Also, since the update of the leverage trading regulation in 2018, European brokers must have protection against negative balances meaning you can’t lose money that you don’t have. We also suggest that you protect yourself using a stop-loss.
A stop-loss is an automatic limit that you can activate for any trade on all the leading brokers in the world. The limit can both be a maximum level or a minimum level, and in order to protect yourself from losses, you set a minimum level. The stop-loss works by closing your position automatically when a certain price is reached.
Summary of Leveraged Trading
Leverage is a concept that provides investors with increased investment abilities by using margin issued by a broker, and it’s a great way of maximizing ROI when trading CFDs and forex in particular. Margin can be issued for most available assets but the amount of credit depends on the market and the broker. Generally speaking, forex provides the highest leverage while cryptocurrencies and stocks get the least.
In order to apply leverage to a trade, the investor needs to borrow money from the broker which naturally also increases the risk. Whenever you decide to close your position, the broker will expect the money you borrowed back whether or not your investment was profitable. Because of this, you need to always apply safety measures to keep yourself protected.
One of the more popular ways of trading with leverage is with CFD brokers and we have recommended the best of the best on this site. Below you find a link of the top leverage trading brokers with a link to the comprehensive reviews we’ve written about them.
Remeber to always use regulated and authorized brokers when you trade CFDs and other derivatives. If you use unlicensed brokers, your safety will be jeopardized and you risk being ripped off.
Find the best trading platform. You capital is at risk when trading. Be careful.