Using Leverage Professionally in CFD Trading

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Using Leverage Professionally in CFD Trading

Contracts for Difference (CFDs) are popular, especially in Europe, mainly due to leverage – the ability to deposit a small amount as collateral and borrow money from the broker in order to trade larger position sizes. Because some people think leverage is 100% and some generally exaggerate when using, we need to clarify a few things, so if you’re just getting started with CFD trading, you’ll know how to use it responsibly.

#1 Leverage in the context of risk management

“What is the most appropriate leverage level?” you may ask, thinking that there’s a certain threshold not to be exceeded. In reality, leverage on its own is irrelevant. You must think from a risk management point of view, meaning you must consider a few variables, not just the leverage. If you risk losing your entire account when the market moves in the opposite, then you clearly must take some actions.

You must adjust your position size and use risk diversification methods in order to not get wiped out by a single losing trade. Risk management is not just about leverage. It’s about position sizing, the risk per trade (how much in % terms you will lose if you’re wrong), your accuracy (meaning the percentage of winning trades), and last but not least, the risk/reward ratio. All these variables will help you calculate your risk of ruin or the probability of all your money.

#2 Reducing the leverage once your account grows

One of the common mistakes around retail traders is to increase their risk and exposure after a winning period. They get overconfident about their trading abilities and take higher risks, only to end will less money than they originally had. Trading is like a marathon and there’s no easy way out of it. Reducing the leverage as your account grows will show that you’re not only treating trading responsibly but will also show great emotional control.

We can’t suggest any particular level for the leverage. Some experts say that leverage higher than 1:10 means you’re gambling, and some consider 1:100 as the maximum level. As we’ve seen previously, you should put leverage into a greater context, not isolate it aside from other important risk parameters.

The bottom line is that risk management is a trading skill and leverage is one of the key components of it. If you can’t afford to invest a lot of money, then obviously you’ll have to use higher leverage at the beginning. Make sure, however, to stick to strict rules of risk management, so the risk won’t get out of control.

Using leverage like a professional

Professionally Using Leverage

One of the most important aspects of trading to grasp is the proper, and professional use of leverage. The use of leverage is arguably the most important aspect of risk management and proper risk management is the top priority of all professional traders.

Managing risk is going to be the single most important factor in your success or otherwise as a Forex trader. You must pay attention to this lesson, as this may be the one factor that is hindering your progress in the markets, as the improper use of leverage will make long term success almost impossible to achieve in the Forex market.

In contrast, the proper use of leverage will prevent you from destroying your account, preserve your capital as a trader, and make you an attractive trader for high net worth individuals to invest in.

Leverage is simply a way of trading with more money than you actually have in your account. Now using leverage can maximize gains, however it can also increase losses too. This is one of the reasons that the Financial Conduct Authority in the UK would like to reduce the amount of leverage accessible to traders.

Too many people have lost their entire trading accounts by the mis-use of leverage. In June 2020 it emerged that one broker had accidentally allowed a trader to open a $5 billion dollar position. The trader, who thought he was trading a demo account, was actually placing $1 billion worth of live orders for US and European equity futures.

The trader ended up with a profit of $10 million dollars, but his initial deposit with the broker had only been $20K. He was using leverage over 200 thousand times above his initial deposit. When you consider that the broker in question only made a profit of $9.6 million last year you can see the enormous risk that leverage can pose. So, the first step in using leverage is to understand exactly what it is.

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What is leverage?

The best way to understand leverage is to think of your trade size (how much you are trading with) vs your account size (how much you have in your account). So, for example, lets say that you have 10000 USD in your account.

If you buy 1 standard mini lot (0.10) – you are now considered to be trading unleveraged. This is because your trade size is equivalent to the amount of money in your account. Your position size is one mini lot, 10000USD, and your account size is 10000USD.

They are the same. In the pictures below you will see an order opened on an MT4 account . The trade size is 1 mini lot or 0.10. A position opened in this scenario would be for a trader not using any leverage with a 10000USD account.

If that trader, with the same account size of 10000 USD, then went on to open a second mini lot position of 0.10, then that trader would be using leverage of 2:1 This means that they are trading with double the trade size in relation to their account.

Their trade size would be 20000 USD , yet their account size is 10000USD. For each subsequent 0.1 trade position the trader opens, the higher amount of leverage they will be using in their account: 3:1, 4:1, 5:1 and so on.

How to use leverage professionally

Now just because you can use leverage it does not mean that you should. Professional traders, working for large institutional banks, brokers and funds use very low levels of leverage. In fact, as a general rule, for working out their trade size they will use unleveraged positions.

As explained above that will mean that their trade size matches their account size. So, a trader, operating a $1 million USD account would only use 10 standard lots as their normal, unleveraged position. At first, it may seem strange that a professional trader would not utilize these high levels of leverage.

So, let us move on to consider some of the key reasons why professional traders are so cautious in using leverage.

The benefits of using leverage professionally

Attract high net worth clients

The first benefit is that it allows a professional trader to attract and retain high net worth individuals and accounts. This is obvious when you think about it. Imagine that you have been entrusted with a $200 million account to trade with. Now, imagine, that through using leverage you have a losing trade that loses 10% of your account.

Now, let’s say that for the next two trades you lose a further 10% of your $200 million account. Let’s say those three losing trades happened in one week. Three losing trades in a row is not an unusual occurrence for any professional trader. It happens. Now, that trader would have to tell their employer and their client that they have lost over $40 million in one week. Enduring that kind of loss is an unbearable mental toll on both the trader and the client.

A professional trader who traded in this way would be removed from their post and clients of high net worth would not be prepared to risk so much of their money in this way. So, when you stop using leverage you are showing yourself to be a trustworthy trader who can manage risk in an acceptable way. Say, in the example above, that instead of risking 20% of their account , the trader had not used leverage and only risked 0.60% of their account per trade. Their total loss would only then have been 1.8%.

That is a an acceptable loss for three losing trades in a row, especially when the winning trades inevitably come along again. If you aspire to be a Forex trader, showing that you can manage accounts in a responsible way is crucial in attracting high net worth investors and will be a key factor in your success. If you aspire to become an online Forex trader, then managing your risk is a key factor you need to master.

What is leverage?

Leverage enables you to get a much larger exposure to the market you’re trading than the amount you deposited to open the trade. Leveraged products, such as spread betting and CFDs, magnify your potential profit – but also your potential loss.

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Leverage is a key feature of CFD trading and spread betting, and can be a powerful tool for a trader. You can use it to take advantage of comparatively small price movements, ‘gear’ your portfolio for greater exposure, or to make your capital go further. Here’s a guide to making the most out of leverage – including how it works, when it’s used, and how to keep your risk in check.

How does leverage work?

Leverage works by using a deposit, known as margin, to provide you with increased exposure to an underlying asset. Essentially, you’re putting down a fraction of the full value of your trade – and your provider is loaning you the rest. Your total exposure compared to your margin is known as the leverage ratio. For example, let’s say you want to buy 1000 shares of a company at a share price of 100p. To open a conventional trade with a stockbroker, you would be required to pay 1000 x 100p for an exposure of £1000 (ignoring any commission or other charges). If the company’s share price goes up by 20p, your 1000 shares are now worth 120p each. If you close your position, then you’d have made a £200 profit from your original £1000.

Unleveraged

If the market had gone the other way and shares of the company had fallen by 20p, you would have lost £200, or a fifth of what you paid for the shares.

Or you could have opened your trade with a leveraged provider, who might have a margin requirement of 10% on the same shares.

Here, you’d only have to pay 10% of your £1000 exposure, or £100, to open the position.

If the company’s share price rises to 120p, you would still make the same profit of £200, but at a considerably reduced cost.

If the shares had fallen by 20p then you would have lost £200, which is twice your initial deposit.

Leveraged

Different types of leveraged products

The majority of leveraged trading uses derivative products, meaning you trade an instrument that takes its value from the price of the underlying asset, rather than owning the asset itself.

The main leveraged products are:

Spread betting (UK only)

A bet on the direction in which a market will move, which will earn more profit the more the market moves in your chosen direction – but more loss if it goes the other way.

Contracts for difference (CFDs)

An agreement with a provider to exchange the difference in price of a particular financial product between the time the position is opened and when it is closed.

Visit spread betting vs CFDs to learn more about the differences between these products.

There are lots of other leveraged products available, such as options, futures and some exchange traded funds (ETFs). Though they work in different ways, all have the potential to increase profit as well as loss.

Which markets can you use leverage on?

Some of the markets you can trade using leverage are:

  • Shares
    A share is a unit of ownership for a particular company, and is usually bought and sold on a stock exchange. You can use leveraged products to open positions on thousands of shares, from blue chips like Apple and Facebook, to penny stocks.
  • Indices
    An index is a numerical representation of the performance of a group of assets from a particular exchange, area, region or sector. As indices are not physical assets, they can only be traded via products that mirror their price movements – including spread betting, CFD trading and ETFs.
  • Forex
    Foreign exchange, or forex, is the buying and selling of currencies with the aim of making a profit. It is the most-traded financial market in the world. The relatively small movements involved in forex trading mean that many choose to trade using leverage.
  • Cryptocurrencies
    Cryptocurrencies are virtual currencies that can be traded in the same way as forex, but are independent of banks and governments. Leveraged products allow traders to gain exposure to major cryptocurrencies, such as bitcoin and ethereum, without tying up lots of capital.

Benefits of using leverage

Provided you understand how leveraged trading works, it can be an extremely powerful trading tool. Here are just a few of the benefits:

  • Magnified profits. You only have to put down a fraction of the value of your trade to receive the same profit as in a conventional trade. As profits are calculated using the full value of your position, margins can multiply your returns on successful trades – but also your losses on unsuccessful ones. See an example of magnified profit
  • Gearing opportunities. Using leverage can free up capital that can be committed to other investments. The ability to increase the amount available for investment is known as gearing
  • Shorting the market. Using leveraged products to speculate on market movements enables you to benefit from markets that are falling, as well as those that are rising – this is known as going short.
  • 24-hour dealing. Though trading hours vary from market to market, certain markets – including key indices, forex and cryptocurrency markets – are available to trade around the clock.

Drawbacks of using leverage

Though spread betting, CFDs and other leveraged products provide traders with a range of benefits, it is important to consider the potential downside of using such products as well. Here are a few key things to consider:

  • Magnified losses. Margins magnify losses as well as profits, and because your initial outlay is comparatively smaller than conventional trades, it is easy to forget the amount of capital you are placing at risk. You won’t be able to lose more than the balance on your account, but you should always consider your trade in terms of its full value and downside potential – and take steps to manage your risk.
  • No shareholder privileges. When trading with leverage you give up the benefit of actually taking ownership of the asset. For instance, using leveraged products can have implications on dividend payments. Instead of receiving a dividend, the amount will usually be added or subtracted to your account, depending on whether your position is long or short.
  • Margin calls. If your position moves against you, your provider may ask you to put up additional funds in order to keep your trade open. This is known as margin call, and you’ll either need to add capital or exit positions to reduce your total exposure.
  • Funding charges. When using leverage you are effectively being lent the money to open the full position at the cost of your deposit. If you want to keep your position open overnight you will be charged a small fee to cover the costs of doing so.

Leverage and risk management

Leveraged trading can be risky as losses may exceed your initial outlay, but there are numerous risk-management tools that can be used to reduce your potential loss, including:

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