Leverage or margin rates are words you will often see in broker
and market maker advertisements and it refers to the size of trades
(or exposure to the market) you are able to place versus the size
of your deposit. An advert offering leverage of 100:1 means that
for every £1 you hold in your account you can gain exposure to the
market of £100. Before running off and exposing yourself to
thousands of pounds of market risk it is important to understand
how leverage can be used and what the advantages and disadvantages
are.
Clearly the main advantage is that for a trader to gain £10,000
of exposure to, for example, a FTSE 100 stock, a CFD provider
offering leverage of 20:1 will only require a deposit of £500 to
place this trade. If you went to a stock broker and asked to
buy £10,000 worth of stock you would be required to deposit the
full £10,000. Therefore leverage allows you to keep the majority of
your money in your bank account instead of at your broker and in
turn potentially allows you to use these funds to place other
trades in other asset classes.
This leads on to an important warning about leverage and one of
the disadvantages of trading in this way. Although you are only
required to place a relatively small initial deposit into your
account to gain a far larger exposure the market you still have the
same potential downside risk as if you were placing all of the
funds with your broker (as per the stockbroker example above).
Therefore it is important not to over expose yourself to the market
when using leveraged products; it is too easy to place a succession
of trades which all use up a relatively small amount of initial
capital without fully understanding that an adverse market movement
could result in a call from your broker for more money (also known
as variation margin) to cover your losing open positions. If you
choose to use the money you had originally held in the bank you can
quickly find yourself having to find additional funds to support
your open position losses or risk having your trades liquidated by
your broker.