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While leverage can be applied to great effect in boosting your trading returns, it also comes with a series of disadvantages, and is by no means a sure-fire way of making money. Leveraged positions can lead to a total wipe-out of your trading balance, and many traders over the years have found themselves falling victim to the negative effects of leverage, leading to significant losses without proper management of their risk. For this very reason, it’s important to make sure you understand the disadvantages of leverage, and take care to ensure you don’t fall victim to overexposure when the markets inevitably turn sour.

1. Potential Scale of Losses

The primary and widest feared drawback of leverage is its potential to scale up losses when the going gets tough. Leverage works by extending your exposure to a particular position beyond the level of your investment, and as such opens up the potential for larger wins.

When markets move against your open positions, be it with margined CFD trading, spread betting, forex trading or any other leveraged transaction, this also means you’re increasing liability to match losses from the total trade (rather than the fractional amount of your investment), not to mention the interest costs associated with holding leveraged positions for any period of time, and the higher commission costs applicable per transaction.

For example, if a leveraged long position on Company X is taken to the value of $1,000, with an initial investment of $50, the trader has the opportunity to reap a profit on the increase in value of the $1,000 position. However, if the $1,000 position falls in value by 10%, the trader becomes liable for the $100 loss in value – even although his initial stake was only $50. Indeed, liability on the downwards side is unlimited, and it is up to the trader to close out losing positions before the broker does it on your behalf, potentially at the expense of other profitable positions and your remaining trading balance.

2. Losses Can Exceed Your Deposit

As if that wasn’t enough, your exposure to leveraged positions is not limited to the amount of your trade, nor is it limited to the balance of your trading account. To the extent to which your liability extends your trading balance, your broker may demand further deposits to covered the stipulated margin requirement, known as a ‘margin call’. However you intend use leverage in your trading, it’s vital to make sure you keep your trading within tight, affordable parameters, and that you take steps to minimise your risk exposure whenever possible to avoid a leveraged catastrophe.

One of the core means by which you can minimise risk when trading on leverage is to set tight stop losses, automatic orders which instruct the broker to close out losing positions when they reach a certain trigger. The idea is to set stops at a limit that is just below the recent lowest price point, such that your position will be reversed if the value of your transaction falls to a new low. While it can be galling to watch a position flip against you and close in a matter of minutes, it is nonetheless worth having a stop in place to prevent runaway losses, and to allow you to focus on other areas of your portfolio without having to pay constant attention to the possibility of rampant, leveraged losses.

3. Leverage Financing Costs

Leveraged positions can also often prove themselves to be untenable, particularly if they’re rolling overnight, and are ongoing positions with a longer-term focus. Long-term positions with margined products can become too expensive if the costs of funding the leverage outstrip the potential profits to be gained, and it is worth bearing in mind the applicable costs that might come to bear the longer a position is open.

Provided all that hasn’t put you off, leverage can be a fantastic tool when used properly, and plays a pivotal role in the strategies of most serious traders worldwide. With the appropriate attitude to risk, and a cautious approach to diversifying your trading portfolio, leverage can provide the rocket fuel necessary to multiply your investment capital and take your trading to the next level.

If you’re serious about trading CFDs, you’re probably all too familiar with how leverage works and the benefits it can have on your trading success. Prolific traders across the world are using leverage to gear up their potential winnings, and to boost their incomes beyond capital restraints, maximising their trading advantage with the help of their brokers and financing partners. Indeed, high-risk investment funds are leveraging billions in principal capital to deliver a return for investors, and with careful and rigorous management of risk leverage can add significant value to your trading endeavours.

1. Increased Exposure with CFDs

Perhaps the most obvious advantage of leverage is that it allows you as a trader to increase your exposure to particular positions, both long and short, where indicators point in a particular direction. When trading CFDs for example, margin requirements are often low enough to offer gearing of as much as 20:1 – effectively allowing 20 times the earnings of a pound-for-pound, unleveraged position to deliver a higher rate of return.

This makes it possible to reap the rewards of a much larger investment, without having to stump up the capital in the first place. Of course, the money has to come from somewhere, and so leveraged positions attract financing costs and thereby become more expense with time. But by using leverage sparingly as a means of amplifying your sure-fire positions, it can be a highly effective tool for maximising your trading profits.

In practice, leverage allows you to fully capitalise on market movements in your favour. For example, Company X shows promising signs for future growth, and a trader takes a long position in CFDs worth $1,000, with a margin requirement of just $50. Assuming the value of CFDs in Company X shows a 10% rise, the gross profit (before interest and commissions) on the $50 investment would stand at $50 – a 100% return on investment.

If the trader has invested in Company X stocks without any leverage, the same rise would have generated a return of $5, or just 10% – thus, the value of leverage is evident in permitting a more efficient use of your investment capital.

2. Offset CFD Capital Losses from Other Investments

Leverage also allows investors to offset capital losses from other trading activities, and assuming an individual trading portfolio isn’t too heavily exposure to debt, a few successful leveraged positions can help re-balance the books and effectively subsidise your other, less successful positions. In this more conservative role, leverage can actually help reduce overall risk exposure, albeit as a highly risky strategy in its own right. For this reason, it’s essential to ensure that leverage is used only as a part of your trading strategy, and does not form the sole backbone of your trading strategy.

3. Greater Profits/Losses

The ability to leverage your trading positions is particularly helpful in generating greater profits, and can play a pivotal role as part of a well-balanced, risk-managed portfolio. However, the value of leveraging any CFD position must be tempered by the risks of markets moving against a trader, and the potentially significant costs associated with wayward trades.

We’ve mentioned at length the dangers of dealing with leverage, and the potential pitfalls associated with ill-advised, leveraged trades. Given the notionally unlimited liability of traders in respect of negative leveraged positions, it is important to take steps to mitigate any such losses, closing out downward positions as early as practical and ensuring sufficient cover across the rest of the portfolio to pick up the slack.

While there are no guarantees in trading, there are a number of ways in which you can stack the odds in your favour, and by employing a considered, intelligent leverage strategy, it can be possible to reduce the likelihood of total financial meltdown, while preserving profitable positions and your trading capital.

When dealing with any margined product, and CFDs in particular, your trading capital is automatically at risk from wayward positions. It’s part of the deal – in order to reap the rewards of leveraging trades, traders have to bear the brunt of leveraged positions that move against them, and the broker will have recourse to any trading balances in the first instance to fund margin requirements for negative leveraged trades.

This means that where your total liability outstrips the initial margin amount on a given transaction, the remainder of your trading account is vulnerable to a margin call from the broker. Importantly, this also includes other open, and potentially profitable, positions, which may be liquidated in order to fund your margin requirements.

If you fail to keep on top of your exposure to negative leaning leveraged positions, you could end up sacrificing much of your remaining trading account in meeting your funding requirements, and there is no bottom limit at which your liability is halted – indeed, you may even be forced to deposit more heavily into your trading account to cover your losses.

Limiting Potential Losses

Thankfully, CFD trading need not be this brutal, and with careful management of mitigation strategies it can be possible to limit the extent to which one rogue trade can affect your remaining trading activity. The most direct way of limiting your losses is to position a stop loss underneath a recent low-point price for the stock, commodity or index on which your contract relies.

A stop loss is an instruction given to the broker ahead of time to close a position when it looks like it could be heading south. The tighter the stop, the more likely it is that a blip could close your position, while looser stops obviously pave the way for more significant losses. Wherever you position your stop loss, it’s important to see stops as a hand-in-hand companion of CFD trading, and a vital component of sensible margined trading.

Hedging Your Possitions

Further to positioning stops on your leveraged trades, it is also possible to take steps to mitigate losses by a process known as ‘hedging’ – effectively taking two contrary positions in the hope that one with offset the other and lead to a profit regardless of the movements of the market. This might be with two differing contracts for difference, or may cross trading instruments and bases – however the hedge is composed, it must take account of inverse correlations, and should attempt to identify trends of contrary price movement to highlight indexes and assets which seem to respond in sync with price movements of another.

This is the main strategy implemented by the billion dollar hedge funds, who rather successfully manage to mitigate losses by winning back earnings that might otherwise have been lost with one-sided exposure.

Using CFDs for Diversification

Along a similar vein, ensuring you have a diverse trading portfolio is a good way of minimising the effect of individual losses. Too much exposure to one asset class or instrument can never be a good thing, and by spreading your wings to encompass other trading strategies and instruments, it is feasible to spread much of the risk associated with more volatile CFD trades.

Much of the process of mitigating losses with leverage comes from first hand experience, and until you’ve felt the heat from a bad position, it’s hard to really stress the significance of taking steps to handle your exposure. That said, by starting off on a cautious footing and with an understanding of the basic ways in which you can protect your trading capital and cut short losses before they take full swing, it can be possible to limit the damage caused by positions that turn out to be less profitable than anticipated.

CFD traders are growing in number, brought about by the widespread appeal of CFDs as an alternative investment instrument. For many, the lure of ultra-high leverage is what draws traders in to CFDs, with hopes abound of substantial returns paving the path to riches.

Of course, in part, CFDs are highly leveraged and as a result they do deliver greater yields than many other types of financial instrument. That said, this leverage must always be accounted for by the trader, even in the bad times, and any monies borrowed off of the broker for leverage purposes must be repaid at the settlement of each relevant transaction plus the applicable finance charges, depending on the duration through which the position has been open.

What Is Leverage?

While leverage is essentially a loan from the broker to the trader to finance a position, the money is applied directly to the position, such that no cash actually changes hands. In spite of this, brokers still require some security in order to enable the leverage portion to go ahead, and this is normally expressed as a percentage value of the total transaction size known as ‘margin’.

The margin is the amount of equity the trader is required to buy in to the deal in order for the position to be leveraged, and as a percentage is fixed against the total transaction size such that a greater margin amount allows a greater overall transaction size.

For most transactions in most markets, margin is usually set at around the 5% mark, which affords leverage at a factor of 20. That means that for each $1 margin covered, $20 can be spent on the total transaction size. So, if the position increases in value by 10%, your return on the $1 margin capital is 200%. And so long as the margin amount remains equal to the 5% (or whatever percentage margin requirement is required with your broker), the position can continue to be funded in this way essentially indefinitely (or until the point at which the financing costs outweigh the benefits of rolling overnight).

Margin Call and What It Means for You

If the position decreases in value at any point over the lifetime of the trade, it’s your obligation to ensure there is enough capital in your account to cover your margin requirement. If you don’t keep up a constant exposure to the position to the tune of the margin requirement set by your broker, you run the risk of incurring a margin call, where the broker effectively calls in your other open positions in order to fund your losses.

This can throttle profitable positions and even result in the closure of your account, so its important that you make sure that you constantly retain a sufficient capital buffer to prevent this kind of action from taking place. For this reason, its vital to always store some capital in reserve in your account, and to take care not to over-leverage your portfolio when making trading decisions.

Leverage is both the joy and scourge of traders in equal measure, and can single-handedly make or break your trading success. For the most part, millionaire traders have got there as a result of leverage, and without this often invaluable tool they would probably still be toiling to build up their trading capital and, bluntly, nowhere near as successful. Indeed, many of today’s most popular trading forms, such as spread betting and CFD trading rely on leverage to a massive extent, and attract new aspiring traders in their tens of thousands each year. But what exactly is leverage, how does it work, and what role can leverage play in your trading activities?

What Is Financial Leverage?

Leverage is essentially loan finance permitted on a given transaction to allow a trader to ‘gear up’ his exposure, without having to invest 100% of the trade value. The broker usually allows a trader to open a position at a much higher value than his current trading account balance, often requiring as little as 5% in margin deposit to allow an individual transaction to proceed. In effect, this allows the trader to earn off the back of 100% of a transaction, at a personal up-front cost of just 5%, (or whatever the agreed margin rate may be).

However, while leverage can have a dramatically positive effect on your trading, it nevertheless presents a range of risks and dangers, and is all too often the ruin of even experienced traders. Leverage can work both for you and against you in equal measure, and the higher earnings of leverage wouldn’t be possible without a corresponding leveraged risk profile.

Financing Costs and Margins with CFDs

In addition to paying financing costs, a negative leveraged position must be paid up, and will solicit the margin call to the extent that your account is unable to pay. For this crucial reason, respecting the threats posed by leverage and monitoring your risk exposure throughout your trading activity is an essential strategy to mitigating losses on wayward trades.

CFDs themselves are margined products, and more often than not are traded with the benefit of leverage, supplied by the broker to the trader to finance particular trades. Just like any other form of loan finance, leverage attracts financing costs in the form of interest, which takes account of the risk of default and builds in a profit margin for the broker in respect of the service (i.e. the leverage) offered.

This obviously makes for a factor that must be considered in attempting to calculate the whether or not a position is likely to yield a profit, and spiralling costs of leverage finance can at times make certain positions unviable.

Leverage can be a double-edged sword, and has the effect of amplifying trading positions across the board to maximise earnings and, unfortunately, losses. As a trader, it’s not advisable to stay clear of leveraging positions if you’re looking to build your portfolio quickly, but it is important to remember to give due consideration to the risks and the pitfalls associated with leveraged trading, to make sure you don’t become another trading statistic.

Why It’s Important To Be Careful Trading CFDs