Investing Basics: What is Leverage?
21 May 2023
Trading on leverage (sometimes ‘gearing’) means achieving exposure to an underlying equity, index, commodity or currency pair for a fraction of the cost of buying the asset outright; this multiplier effect is achieved by borrowing against an initial investment and can enhance gains and magnify losses in equal measure – by Christian Leeming
Gains can be greatly enhanced although losses may exceed the initial investment; leverage works when gains exceed the cost of borrowing associated with taking a certain position – companies use leverage when they issue bonds (debt) to finance operations in the hope that the returns that are achieved outweigh the cost of servicing the interest payments to bondholders.
Most people that have borrowed money to purchase a property have used leverage; they have leveraged the value of their deposit to secure a mortgage that gives them ‘exposure’ to a more valuable asset than they could afford to purchase outright – their house.
Leverage is a key feature of CFD trading and the deposit (margin) required to trade a particular stock or index varies; in conventional dealing, you would have to pay the total value of the shares you wish to purchase, so If you wanted to purchase 10,000 Barclays shares at the market values of 260p per share, that would cost £26,000 (10,000 x 260p).
Most people that have borrowed money to purchase a property have used leverage
By trading CFDs you only have to deposit a small percentage of the total trade value whilst maintaining the same level of exposure; if Barclays is traded at a margin rate of 15% the investor is only required to deposit £3,900 (10,000 x 260p x 15%) plus commission to trade the same £26,000 exposure.
CFD margins range according to the liquidity and volatility of an underlying investment; the most popular shares may vary from 5% to 25%, whilst margins for popular indices such as the FTSE100 can be as low as 1.5%.
Because of the relative stability and liquidity of currency markets, forex can be highly leveraged and contracts can sometimes be offered with 400:1 leverage.
Leveraged trading can magnify gains and in the above example, were Barclays’ share price to rise by 10% it would deliver a net profit of £2,600 – a return on investment of 67% rather than the 10% that would have accrued from a direct investment.
Whether you have backed the value of the underlying asset to rise or fall, your profit or loss is based on the full position delivered by the product which can deliver very large gains in relation to the size of the original investment, but it can also magnify losses should you get it wrong.
An initial investment is referred to as a margin or deposit requirement and the product provider requires this to cover any potential losses that may accrue from a position. Some products require margins as a fixed amount per contract, while others are calculated as a percentage of the value of the position.
a return on investment of 67% rather than the 10% that would have accrued from a direct investment
Leverage may be a great way to magnify your exposure in a particular market, but leverage not only magnifies your potential profits but also your potential losses and It is possible to lose much more than your initial margin if the market turns against you.
The main benefit of leverage is that it frees up your capital to diversify your holdings because you only have to commit a fraction of the value of the assets you are interested in and you can take a larger position than with a direct holding.
However, when trading with leverage the investor gives up the benefit of taking ownership, in the case of shares, or delivery, in the case of futures and they may also be called upon to put down more margin and cover any losses should the market go the wrong way.
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