What is Leveraged Trading?
If you are currently trying to teach yourself the art of stock market trading, you may have heard the term leverage quite a lot. So what is leverage and how do people use it when trading stocks and shares?
Leverage is a commonly used term when people talk about spread betting and CFD trading (Contracts for Difference). When you leverage anything in life you are effectively borrowing money to allow you to buy or trade in a certain entity. When you borrow the money to buy a car you have effectively leveraged the purchase of that vehicle by putting down a deposit and borrowing the rest. When it comes to trading through a spread betting firm you are engaging in leveraged trading. Leveraged trading allows you to make a bigger trade than you actually have the money for by ‘borrowing’ the rest of the money from a spread betting company. This could potentially lead to bigger, more magnified gains but it could equally lead to bigger or more magnified losses which exceed your initial investment amount.
Let’s consider an example of leveraged trading.
Let’s imagine that you want to trade in Exxon Mobil through a spread betting platform. The company is currently trading at 100/102 – the sell price being 100 and the buy price being 102. We can see here that the spread on this trade is 2 points.
Now let’s assume that you want to buy into this trade at £2 per point because you think that the price of Exxon Mobil is going to rise. Exxon Mobil has a margin rate of 5%, so you only need to deposit 5% of the total value of the position with the other 95% leverage being funded by your broker. In this example your position margin will be £10.20 which is equal to 5% x (£2 x 102).
How might the leverage affect your returns?
The leveraged element of the trade has the potential to have a positive or negative impact on your trade.
Let’s see what happens if the price of Exxon Mobil rises in the coming week as you thought it would. Over the coming week the price of Exxon Mobil rises to 152/154. As you are clearly in profit you make the decision to close out your trade, selling at the current sell price of 152.
The price has risen by 50 points from your initial 102 buy price. As it has moved in your favour you can multiply this 50 point rise by your stake of £2 to work out your gain, which is £100, a gain which could simply never have been achieved if you were trading without leverage.
What about if the market were to move against you though?
In this case we can easily see that if the market were to move 50 points against you rather than for you then you could potentially lose £100, so the leverage can have a negative effect as well as a positive one depending on which way the market swings.
So hopefully you now have some understanding of what leveraged trading involves. You are effectively putting a deposit down on a bigger trade with the rest of the money for the trade being funded by the broker. It is you however who is liable for the results of the full overall trade. If things go your way then you will see the full benefit of the leverage. If things go against you, then you will feel the full brunt of any leveraged losses.