Let’s introduce the second risk, leverage:
Leverage risk
Leverage is always there in margin trading, which we introduced in our Margin Trading Demystified course. In margin trading traders effectively borrow money to fund part of a position.
Note: Traders don’t actually borrow the money – the design of a CFD contract means you and your broker are agreeing to swap the difference in price. You won’t be able to go into your trading account and see a lump sum deposited by the broker.
Leverage increases the return on capital…
Traders use leverage to enhance the returns on profitable trades, let’s look when Dax increases 1%.
| Dax example | Initial CFD trade (buy 1 @ 10500) | Price up 1% to 10605 |
| Notional position | €10,500 | €10,605 (+1%) |
| Margin/deposit amount | €525 | €630 (+20%) |
| Broker funded amount | €9975 | €9975 |
The trader’s deposit, the capital they have had to put up to trade, has increased 20%, while the notional position has increased just 1%. This is the power of leverage.
..but also decreases it
Unfortunately, leverage enhances losses just as powerfully. Let’s look at what happens if Dax fell 1%:
| Dax example | Initial CFD trade (buy 1 @ 10500) | Price down 1% to 10395 |
| Notional position | €10,500 | €10,395 (-1%) |
| Margin/deposit amount | €525 | €420 (-20%) |
| Broker funded amount | €9975 | €9975 |
Ouch, a 20% loss on the trader’s capital.
Enhances a trader’s resources
Leverage can also enhance a trader’s pool of trading resources, with leverage traders can expose themselves to a greater amount of an underlying asset. Using a basic example, a trader has capital of £500 and trades shares. If trading cash shares with no leverage the maximum exposure is £500. If trading with 5:1 leverage, the maximum exposure jumps to £2,500.
Starting to managing leverage
Leverage is a big downside risk, and in our opinion, it is pretty badly managed. Traders that don’t understand how leverage works or how to manage it can expose themselves to huge risks, and potentially career-ending losses without knowing it.
This lack of understanding normally afflicts inexperienced traders, full of confidence, thinking they can’t be wrong. But, if you’ve ever nursed a big loss made worse by leverage don’t get too down, experienced traders do it as well – just look at the banking crisis when Lehman Brokers leveraged the whole company up to 31:1….the rest is history.
Regulators of the retail derivatives industry have released that it is a poorly understood risk and one of the main sources of losses. In response, leverage caps have been introduced or are being considered around the world. In August 2018 the EU introduced the following caps:
- 30:1 for major currency pairs;
- 20:1 for non-major currency pairs, gold and major equity indices;
- 10:1 for commodities other than gold and non-major equity indices;
- 5:1 for individual equities and any underlying not otherwise mentioned; and
- 2:1 for cryptocurrencies.
Before the cap, the average leverage offered in Cable (GBPUSD) was about 200:1 and in some instances went as high as 1000:1. Just think, with 1000:1 leverage a 0.1% price move could wipe out a trader’s deposit!
These are our pointers for managing leverage:
- Leverage risk occurs when money is borrowed.
- In margin trading, the trader is effectively borrowing money to fund their notional position.
- Leverage increases a trader’s return on profitable trades…
- …it also decreases the return on losing trades in equal measure.
- Leverage gives the trader more resources to trade with.
- Leverage is one of the biggest risks margin traders face.
- Regulators realise this and have started to cap leverage levels.
- You can start to manage leverage by understanding it, taking responsibility, thinking in terms of the notional and by being humble.
