A Lesson in Leverage

Submitted by Marco Palmero on 17 August, 2009 - 17:33

A Lesson in Leverage

One of the main advantages of CFD Trading is the ability to apply leverage. The most important part of trading with CFDs is to understand how they work and how the leverage can act like a double edged sword. A trivial topic to discuss but an important lesson to reiterate. CFDs can be traded long or short, as such you can lose out either way if the market goes against you. What is leverage? Leverage is defined as the mathematical process of allowing you to trade with a small amount of outlay to gain a full exposure to the price fluctuations on the shares, stocks or any other underlying securities like forex or commodities.

Before you enter into a leveraged position, it is best that you plan ahead and visualise what will happen - so you are mentally prepared for what could happen. Trust me, that's a very critical exercise. And because you are leveraged, your potential losses (and gains) are magnified. As part of your preparation you should also develop a risk management plan which will detail what price you will exit if the price of the security moves against your position to limit the amount you lose.

Here is the very trivial lesson in leverage:
Trading shares and stock via direct ownership on the stock exchange, leverage = 1:1

  • Initial capital = $100,000
  • 10 percent increase of share price = 10 percent profit; capital is now $110,000
  • 10 percent decrease of share price = 10 percent loss; capital is now $90,000

Trading a leveraged financial product:

  • Initial leveraged capital = $5,000 (5% outlay for $100,000 exposure)
  • 10 percent increase of share price = 200 percent profit; capital is now $15,000
  • 10 percent decrease of share price = 200 percent loss; capital is now -$15,000 - but in reality you may have been margin called close to $0 so you may only sustain 100 percent loss