Leveraged trading. What is it, how does it work and why might you consider it?

The prospect of outsized gains for a low initial investment has understandable appeal. Leveraged trading is a popular option to achieve potentially large returns from a small outlay. However, it needs to be handled with care, or ‘get rich quick’ can become a fast way to lose money.

Leveraged trading, also known as margin trading, is when a small amount of capital is used to take exposure to larger trading positions. A position with 10:1 leverage would mean that the trader would have, for example, £10,000 of exposure, while putting up just £1,000 in capital.

Investors don’t have to tie up significant capital to take large positions. This means they don’t have to liquidate assets elsewhere to gain the exposure they want (though this may be necessary if the position moves against them). Equally, it can allow traders to take exposure to assets that may otherwise be difficult or expensive to access.

Although there are a number of ways to introduce leverage into your investments, contracts for difference (CFDs) are a popular option. With a CFD, investors are trading on price movements rather than owning the asset itself. This brings in a broader range of assets to trade on – commodities, currencies and indices for example - and lower minimum investment levels.

Potential for gains (and losses)

If the position goes in a trader’s favour, they can make many times their money. Taking the example of a position with 10:1 leverage: if an investor wants £50,000 worth of exposure, with a margin level of 5%, they will make an upfront investment of £2,500. If the current share price is £100, they are exposed to the equivalent of 500 shares.

If those shares rise to £125, the trader makes £25 x 500 or £12,500 – five times their original investment or 500%. Had they bought the shares outright, they would have made the same amount, but they would have had to deploy £50,000 upfront. In percentage terms, their gain is far lower – just 25%. These chunky gains are part of the appeal of leveraged trading.

However, leveraged trading also comes with the potential for significant losses. If the share price for the company above dropped to £75, the investor would have lost £12,500 and need to find another £10,000 to add to their margin payment of £2,500 to close out the position. If they kept the position open, the broker may ask for further margin payments to keep the trade open.

With this in mind, most experienced leveraged traders do not leave themselves with significant, unhedged open positions. No matter how good your analysis, it is always possible to be blind-sided by events – the Covid-19 outbreak is a good case in point.

Margin requirements

Margin requirements will vary from broker to broker and from asset class to asset class. For example at Fineco our margin for trading in CFDs may vary from 3% for FX to 20% on shares: For client classified as potential rate can be lower.

While the initial margin required can be small, if a position goes against you, you may be required to commit more money to the trade. Equally, the broker may wind up the trade if the margin call exceeds a person’s available funds.

If this approach doesn’t appeal, you can also use instruments with inbuilt leverage, such as certain ETFs. Although any falls will be magnified by the amount of leverage, investors cannot lose more than their original investment.

Key points for trading on leverage

Leveraged trading requires some appetite for risk. It is worth starting small and in specific asset classes. It is important to get to know a market and practice with small amounts of money before taking larger positions - financial markets are often subject to unexpected events.

Make sure you understand your trading style, your strengths, weakness and behavioural quirks (everyone has them). There are certain common mistakes. Attempting to recoup losses by betting larger and larger amounts has long been a peril for traders, even since Nick Leeson brought down Barings Bank in 1995 by attempting to do it.

Putting parameters round a trading strategy can help manage behavioural biases and keep loss es to a minimum. These may be hedging strategies, stop loss positions or similar.

Also, check how much you’re paying to trade. You don’t want gains to be eaten up by costs. At Fineco, we don’t charge any additional transaction costs or spreads for trading in share CFDs, which means you keep more of your profits.

Leveraged trading offers the potential for outsized gains for a small upfront cost. However, it needs to be done with care – losses are magnified as well. Having a good trading strategy in place will help manage some of the risks.