Leverage reduces capital requirements by providing additional investment capacity by financial intermediaries to investors.
The rise of derivative financial products such as CFDs has come with recent focus on the advantages and disadvantages of leverage, but leverage is not really new. Indeed, any type of investment that uses debt is necessarily leveraged.
What is leverage ? How do you calculate leverage ? How do you trade without leverage ? Why use leverage ? What leverage should I use to trade ?
Here is a comprehensive summary of what you need to know to boost your trading performance through the proper use of leverage.
By definition, leverage is the use of debt to increase investment capacity. In a leveraged investment, an investor contributes less capital than is needed to complete the transaction, with the difference being financed by a debt contracted with a financial intermediary. When the investment is successful, the investor receives the gains generated by his own funds, but also those generated by the borrowed funds. In such a situation, the leverage effect multiplies the investor's gains.
On the other hand, when the investment fails, the investor must assume the losses on his own funds, but also on the borrowed funds... The leverage effect then becomes a sledgehammer effect and multiplies the investor's losses. Leverage is often used by individuals when buying real estate on credit or by companies when financing an investment project through debt, but it is also and especially popular with stock market investors.
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In order to tie up less capital in their securities or trading account, active investors often use leverage. To do so, they can either choose to buy financial products on the organized market, by buying shares on the Deferred Settlement System (DSS) or futures contracts, or opt for the over-the-counter market by buying CFDs, for example. While the leverage available on the organized market is limited (x5 for the SRD), the leverage offered on the OTC market by CFD brokers is more flexible, although the Sapin II Law has limited the leverage to x20 for stock indices and x100 for FOREX.
Leverage is the total amount of a trading position divided by the capital tied up to cover the risk of that position (the margin).
x10 leverage means for example that one tenth of the position amount will have to be blocked as a guarantee on the trader's account. To open a position of $10,000, the trader would have to put up $10,000/10 = $1,000 as collateral. In reality, an investor's trading account usually shows the amount of margin used (dedicated to cover the risk of current trades) and the amount of margin available (present in the account, but not used at the moment).
To authorize the trader to open a new position, the broker checks whether the available margin is sufficient to cover the margin requirements of the position. If this is the case, the entry into the position is authorized. If not, the order is rejected, and the trader is forced to add funds or close part of their current positions before they can open a new position. When the markets move against the trader, the unrealized losses reduce the available margin. When margin falls to zero or goes into negative territory, the broker may forcibly close the positions in the trading account. The trader is then the victim of a margin call.
To invest without leverage or trade without leverage, a trader cannot open trading positions whose total amount exceeds the money deposited in the account. When the size of the positions is equal to the money deposited in the account, the leverage is equal to 1, and the investment is made in cash. In some situations where the investor decides to keep a portion of unused cash in the account, the investor will trade on an under-leveraged basis, i.e. with negative leverage.
Although leverage can help increase the performance of a trading account, it is important to remember that this increase in earning potential is accompanied by a proportional increase in the potential for loss, and in particular a risk of debt (since the leveraged investment is made on credit). To properly manage the risks of leverage and to take full advantage of this mechanism, it is essential to adopt good risk management rules.
Good money management rules allow you to use leverage to adjust the size of your positions according to the volatility of the market and to work with a constant level of risk for each new trading session. For professionals, leverage allows them to avoid tying up all the capital they need to put their money to work elsewhere. By investing in diversified and uncorrelated investments, leverage allows to optimize the risk/return ratio of a portfolio (the losses of a leveraged stock market position can, for example, be offset by the gains of a real estate investment, or vice versa).
Understanding the risks and the power of leverage is essential to perform on the financial markets. Now that you know what you’re doing, all you have to do is handle this double-edged sword with care!