Benefits of trading with leverage
If you’re unfamiliar with trading derivatives like CFDs, then you’ll need to know about two big concepts: margin and leverage. There are some great benefits that come with trading with leverage – but there are some risks too. Here’s what you need to know.
What are leverage and margin?
By using leverage, CFDs let you gain full exposure to a market using only a fraction of the capital you would normally need. Traders use leverage to get bigger returns from small investments.
When trading leveraged products, you deposit a certain amount of money with your broker, and the broker will then allow you to trade bigger positions. Effectively, the broker is lending you the balance for these bigger positions.
Your profit or loss is based on your full-size position, so the amount you gain or lose will be high in relation to the actual amount you’ve committed to each trade.
The more leverage you have, the bigger positions you can take, and the bigger your swings of profit and loss can be.
Now, it’s important to understand margin when looking at leveraged trading.
Margin is the money you need to lay down in order to open a leveraged trade.
The leverage ratio determines the amount of margin you need to have in your account to open a position. Margin is expressed as a percentage of the deposit while leverage is expressed is expressed as a ratio.
Margin rates and leverage ratios vary across different regions and asset classes.
Leveraged commodities trades, i.e., oil, tend to use a leverage ratio of 10:1 in the EU, so the required margin would be 10%. In many other countries, the margin requirement is 5%. In this case, the leverage ratio would be 20:1.
One aspect of trading with leverage traders like is the fact that it frees up capital. Because you only need to put down a fraction of an asset’s total value, you would have more capital to spread around, allowing you to open more positions on different assets.
Portfolio diversification is always a good idea, as it can help mitigate risk. Potential losses from one trade could be offset by profits in another.
What is leverage used to trade?
Leverage is used to trade derivatives like oil Contracts for Difference (CFDs). These are what’s known as leveraged products. Traders like them because they can control CFD trades using a smaller initial outlay than if they were to purchase the underlying asset to own.
With CFDs, you trade on price movements. So, if you were trading a WTI oil futures CFD, you would be trading on the price movements of a barrel of West Texas Intermediate (WTI) oil, rather than buying any barrels to own and holding onto them in case the price rises.
You can use leverage to trade on oil and gas futures, as well as other assets like company stocks, exchange traded funds, cryptocurrency, and forex.
A leveraged trade
Let’s look at an example
With a WTI CFD, you would be trading on the price movements of a minimum of 10 units of WTI oil (i.e., ten barrels).
If the oil price is $60 per barrel, your exposure would be $600 (10 x 60).
In this example, the oil futures trade requires 10% use 10% leverage as standard, your initial margin would be $60 (10% of $600).
If the price of oil rises by $1, you would then make 10 x $1, so you would come out with $10 of profit.
However, if the price fell by $1, you would lose 10 x $1, and take an $10 loss, because you are trading on margin.
Benefits of trading on leverage
The main benefits of undertaking leverage trades are:
- Leverage frees up capital because you only have to deposit a fraction of the value to open a trade
- You can take much larger positions than would be possible when trading the underlying asset. This means you can get the most out of your capital, and perhaps invest in a range of different assets, instead of restricting yourself to one or two.
- Your profits are multiplied
Risks of trading on leverage
- You do not own the underlying asset you are trading on
- If the market goes against you, you could be called upon to deposit a greater margin to cover your losses.
- Most importantly, your losses are multiplied.
All trading is risky, but the losses from trading with leverage can be magnified considerably. Only commit if you can afford to take any potential losses. It’s always advised you deep research before committing any capital.
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