Understanding Leverage

In CFD trading, you can trade with leverage which means you are only required to provide a small portion of capital needed to fund your market positions. Learn how leverage works in the financial markets.

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Leverage requires that a trader deposit a small down payment on the capital required to control a market position. This required capital is known as “margin.” The necessary funds beyond the margin for maintaining a position in the market are provided by the broker.

For example, let us assume you want to buy 100 shares of a company’s stock which are currently being priced at $100 per share. With a traditional stockbroker, you would need to provide $10,000 in capital to open this market position, excluding any commissions or other fees or costs. If the company’s stock appreciates to $120, the value of your market position will be $12,000. This means you would have gained $2,000 or 20% of your initial invested amount. Alternatively, if the market had gone down by $20 to a price of $80, you would have lost $2,000 or a fifth of your initial invested capital.

On the other hand, if you had a broker that was offering leverage, the situation would look quite different. If the broker required a 10% margin, you would need to only deposit $1,000 to control 100 shares of the company’s shares in the market. Then, if the market moves up to a price of $120 per share, you would have gained the same $2,000 on the trade. However, the difference is that you would have had to invest a much smaller amount of capital for a gain of 200%. Now, if the market had moved downwards to $80 per share, you would have lost $2,000 which is twice the amount of your initial capital investment.

As you can see from these examples, trading with leverage does provide you with increased potential for larger profits. However, it does come with more risk of large losses which you should always be aware of.