Using leverage in trading means you can get full market exposure with just a small initial deposit. It’s a common feature of trading instruments, such as CFDs and spread bets.Let’s take a look at how leveraged trading works, and the risks it creates.
- What is leverage in trading?
- How does leveraged trading work?
- Margin rates per market
- Understanding the leverage ratio
- Leverage ratios by market
- Ways to use leverage in trading
- Benefits of leveraged trading
- Risks of using leverage in trading
- How to manage your leverage risk
- How to start leveraged trading
What is leverage in trading?
Leverage in trading is a mechanism that provides you with increased exposure to an underlying asset. You only need to put down a small initial deposit to open a position, and your provider will loan you the rest.
For example, if you’re trading 10 shares worth a total of £1000, but you have a 20% margin rate, you’d only need to pay £200 to open the trade.
How does leveraged trading work?
Leveraged trading works by using a deposit – known as margin – and borrowed funds to make up the full value of a position.
While the profits from a leveraged position are based on the full market exposure, which can magnify your gains, so are the losses. This is what makes it so important for you to understand how leveraged trading works and how to manage the risks involved.
For example, say you want to buy 10 Apple shares at the current market price of $135.
To open a traditional investment position, you’d have to pay the full $1,350 needed to your stockbroker, who’d buy the shares for you – excluding any commission and other charges. If the shares went up by $5, you’d have $50 profit (5x10) but if they fell by the same amount, you’d have lost $50.
When you trade on margin, you’d only have to put down a deposit. Let’s say your initial margin was 20%, that means you’d need to pay $270 to get the full market exposure of $1,350.
You’ve only put down a fraction of the full cost, but your profit and loss are still calculated using the total value of the position – creating a magnified exposure. So, if the shares increased by $5, you’d still make $50 and if the shares fell by $5, you’d lose $50.
Once you’ve opened a position, you’ll need to keep enough money in your account to cover the margin requirement, or you risk being placed on margin call – which we’ll go into later.
With City Index, your margin is calculated automatically in your deal ticket once you’ve entered your deal size. Open an account or create a demo account to view our trading platform.
For forex trading, you can also use our free online margin and pip calculator to see how much you’d need to pay to trade currency pairs.
Margin rates per market
With City Index, your margin rates per market will vary – so a forex margin rate will be different from an oil margin rate.
The larger your trade size, or the higher the risk associated with the trade, the greater the margin requirement is likely to be. Here’s a breakdown of our margin requirements per market.
Understanding the leverage ratio
Once you know your margin rate, you can start to work out your leverage ratio – which is your total exposure compared to your initial margin. Your leverage ratio will vary, depending on the asset, your provider, how risky the market is and how large your position is.
The most common leverage ratio formula is:
Leverage = margin/total exposure
When you open a standard investment position, your leverage ratio is 1:1, because for every $1 you invest, you’re getting £1 of exposure to the market. So, if you pay £1,000, you’ll get £1,000 of an asset.
But when you trade with leverage, the relationship between your capital and your exposure is different. Here are a few examples of how different ratios would impact a £1,000 outlay.
Leverage ratios by market
Leverage ratios will vary from market to market, but also depend on how much margin you put down and what your total available capital is.
They’re highest in the forex market, where it’s not unusual to see a leverage ratio of 50:1 or 100:1. That’s because forex trades in such small increments, sometimes only moving by 1% per day. In order to profit from these small movements, traders have to make use of leverage.
For example, a forex leverage ratio of 100:1 would mean that for every £1 they put in, they get £100 worth of exposure. So, to get an exposure of £33,000, a trader would need a margin of £333 or 3.33%.
Most other markets – such as shares and commodities – come with smaller leverage ratios from 2:1 up to 15:1, because the markets fluctuate in a much wider range.
On a 5:1 ratio, for every £1 a trader uses to trade a share, they’ll get £5 worth of exposure. So, to get exposure of £10,000, they’d need a margin of £2000 or 20%.
While higher leverage ratios may seem appealing, it’s important to be aware that excessive leverage can be extremely dangerous – especially if you aren’t managing those risks properly. You’ll want to steer clear of providers who offer high leverage without the appropriate protection.
The FCA has put a limit on the leverage that CFDs and CFD-like options can have, which is between 30:1 and 2:1, to protect retail clients from excessive risks.
Roughly speaking, our City Index margin rates would translate to leveraged ratios of:
|Leverage ratio from*
Ways to use leverage in trading
There are a variety of ways that you can incorporate leverage into your trading strategy. Here are some of the most popular leveraged instruments:
Contracts for difference (CFDs)
CFDs are an agreement between you and a provider, like City Index, to exchange the difference in the price of an asset from when you open your position to when you close it.
Learn about what CFD trading is
Spread betting involves putting a bet on which direction a market will move. If your prediction is correct, you’d profit, and if it was incorrect, you’d lose. Spread betting is only available in the UK and Ireland.
Trading futures involves entering a contract to buy or sell an asset at a specific price on a specific date in the future. At the point of expiry, your profit or loss would depend on how far the market had moved.
With City Index, you can speculate on futures prices with CFDs or spread bets.
Learn more about futures contracts
Options contracts give you the right, but not the obligation, to buy or sell an asset at a set price – known as the strike price – on a set date of expiry. Your profit or loss would be determined by how far the market has moved, and whether your strike price has been met or not.
With City Index, you can speculate on options prices with CFDs or spread bets.
Find out more about what options trading is
Benefits of leveraged trading
There are a number of benefits to using leverage in trading – but also a number of risks, which we’ll get to in a moment. The main reasons traders use leverage are:
- Magnified profits – as we’ve already seen, using leverage means you only need to put down a fraction of the value of your trade to receive full market exposure. But profits are still calculated using that full value, so trading with leverage can create greater returns
- Better use of capital – leverage can mean you commit a smaller amount of your overall available capital to each position, freeing up money to be put into a greater number of opportunities. However, it’s important to be aware of your total exposure, which is what your losses will be calculated on
- Going long and short – most leveraged products are also derivatives, which means you won’t ever take ownership of the underlying asset. Instead, you’ll be speculating on the market price. This comes with the benefit of enabling you to trade on markets that are falling in price, as well as those that are rising
Risks of using leverage in trading
The benefits of leverage are evident, but the risks can sneak up on unsuspecting traders. So, it’s vital you understand them and how to manage your risk.
- Magnified loss – although your initial outlay is smaller, you’re actually putting a much larger sum at risk. You can’t lose more than the balance in your account, but you could end up losing more than the initial deposit that you put down. That’s why it’s always important to consider your trade as a whole, and never risk more than you can afford to lose
- Margin call – if your losses start to increase, you could get placed on margin call – which means you need to close out your position yourself, reduce the size of your trade or add additional funds to your account to cover any losses. We’ll notify you via email if this happens. But, if you leave your position open and it drops to 50% of the margin requirement, we'll close it automatically
- Funding charges – as you’re basically borrowing money from your provider, you’ll usually be charged a small fee to cover the costs involved. Think of it like paying interest on a bank loan
How to manage your leverage risk
We offer a huge range of trading tools that you can use to plan trades and seize opportunities. But we also have risk management tools that can help protect your trades from the negative impact of leverage, such as:
Attaching stops and limits to your positions sets predetermined levels at which your trade will close, allowing you to protect yourself from losses and lock in profits.
Stop losses close automatically if the market moves against you, restricting your potential losses to a known amount. It’s important to note that in certain conditions, markets can move quickly, which might result in your stop not being triggered at the price you set.
Guaranteed stop-loss order
That’s why we also offer guaranteed stop-loss orders (GSLOs), which are always filled at the level you’ve set – even if there’s gapping or slippage in the market. They’re free to attach, but you’ll be charged a small premium if they’re triggered.
Take profits, on the other hand, enable you to close your trade once you’ve hit a certain amount of profit, locking it in before the market can turn.
Learn more about take profits and stop losses in the City Index Academy.
Margin Level Indicator
This is an in-platform tool that shows you the level of cover you have for open positions. It’s located at the top of your trading platform. It will display one of these scenarios:
- Sufficient margin
If your margin level indicator is greater than 200%, this will show as > 200%. This means that you have sufficient funds require to keep your positions open
- Your trade is at risk
If your margin level falls below 200%, the margin level will display a percentage between 80% and 200%. You are at risk of being placed on margin call
- Insufficient margin
A warning symbol will be displayed next to the margin level if it drops below 80%. Should your margin level fall below 50%, you no longer have enough funds in your account to cover your total margin and your positions are at risk of being closed
How to start leveraged trading
To get started trading leveraged products with City Index, you’ll need to:
- Open a City Index account, or log in if you’re already a customer
- Search for the market you want to trade in our award-winning platform
- Choose your position and size, and your stop and limit levels
- Place the trade
Or you can try trading with leverage in a risk free environment by signing up for our demo trading account.