Guide to leveraged trading

Introduction: what is leverage?

Leverage – borrowing funds from your broker to magnify the size of your positions – is everywhere in CFD trading, since CFDs are a leveraged product. Leverage means trading on margin, borrowing money from your broker to control larger positions than you could otherwise with your capital. As discussed in this article, using leverage refers to the ratio of margin equity – funds in your account – compared to the size of a position. CFD traders may use more or less leverage depending on the position, and habits vary between traders. In practice, leverage is essential for making work strategies that rely off very small market movements such as intraday scalping , but used incorrectly leverage can have a strongly negative impact on your returns. Since leverage allows traders to deal in bigger contracts than if they were forced to fully fund their account, magnifying potential gains alongside potential losses, traders need to be extremely careful and observe precise risk management practices. Knowing how to use leverage successfully requires an understanding of your own strategy, its expected win rate, and the profits required for it to break even, and should be viewed as an extension of position sizing.

Strategies that benefit from leverage

Some strategies are more or less impossible without the use of leverage, while others are badly suited to it and best traded with little or none. Whether or not to use leverage depends on both your trading style and target market, with forex best suited to leverage, while using large leverage ratios on single stock CFDs requires greater care. The range of leverage offered to ADSS traders goes from 1:1 to 500:1 depending on the market and account type, so there is a level available to suit all risk appetites. In terms of non-traditional asset classes, leverage is normally much less necessary and should be used at lower ratios in crypto markets. Scalping is a strategy that requires some leverage, since the very small intraday movements involved normally are not significant enough to turn a real profit without it.

Target profitability rates fluctuate wildly from strategy to strategy, and are often not realised in a real market environment. We are on surer ground when measuring volatility, and accordingly ADSS offers greater potential leverage for less volatile assets, so reserve currency FX traders can use far more than crypto index fund traders. In terms of different strategies, momentum or trend following strategies are more popular with leveraged traders because they (usually) have a higher win rate than mean reversion: mean reversion strategies also carry a greater risk of losses if overleveraged.

Trend following

Trend following strategies work by identifying an existing trend after it forms and joining in before it corrects. They are among the simplest strategies, and often the most effective, especially in the longer term in markets (equities) that skew long. However, it’s crucial for traders employing trend following strategies to manage leverage carefully. While leverage can enhance profits during trending markets, it can also exacerbate losses if the trend reverses suddenly. Therefore, risk management techniques such as setting stop-loss orders and using position sizing based on volatility are essential for mitigating the downside risk associated with leveraged trend following. Additionally, it’s important to monitor the market closely for signs that the trend may be weakening or reversing, allowing traders to exit their positions before suffering significant losses.

Mean reversion

Mean reversion strategies involve identifying failing trends which are about to reverse, then trading against the trend as this happens. In practice the division between the two can become a little blurred, since if a trader waits until after the correction has established itself it is arguable he is now trend following the new trend. But as a general rule mean reversion strategies are forward looking and involve taking positions against the prevailing market direction; this means losses can rack up swiftly if the trade goes the other way. Many traders use leverage with mean reversion strategies, especially when using tight stop losses and take profit levels to deal in minor moves.

Riskier strategies: low leverage

Crypto markets limit traders to lower maximum leverage, and the sort of margin on offer is not necessary to profit in these highly volatile markets. There is an inverse relationship between the volatility of a market and the appropriate level of leverage – one way of thinking about high leverage trading is that it is useful for squeezing profits out of small market movements. The nightmare scenario for a leveraged trader is a previously stable market that suddenly becomes volatile: probably the worst historical example of this was the Swiss franc’s sudden, un-warned abandoning of its price cap in 2015. Because the CHF had a reputation as a safe haven currency, many brokers offered high levels of leverage on the currency, since it was linked to a developed economy and held as a reserve by traders worldwide. Abandoning the cap led to an almost 30% fall in EUR / CHF in a single day, an unheard of move in forex markets. Naturally, leveraged traders holding long EUR / CHF positions faced formidable losses.

The Swiss franc is an extreme example, but even seemingly stable FX CFD markets can see periods of volatility. Trading with significant leverage is inherently more risky, so traders need to be on their guard for increases in volatility. As a general rule, higher levels of leverage should be used only be experienced, sophisticated traders, who are capable of accessing the risks involved. If not, traders run the risk of being blindsided by turbulent markets, and in FX markets in particular traders rely on central banks to not upset markets without warning. The Swiss central bank’s failure to do so is one reason ADSS offers our clients lower maximum levels of leverage on the Swiss franc than for equivalent FX CFD markets.

Leverage and margin

Margin trading involves borrowing funds from your broker to fund positions. The concept is simple, but even experienced traders need to be careful when funding trades this way due to the risk for magnified losses. There is a certain amount of specialised vocabulary that comes with margin trading, the key terms of which are explained below.

Margin equity

Margin equity is the amount of money in a margin trading account at any given time. Margin equity may also be referred to as funds, balance, cash balance, or cover. Maintaining the right level of margin equity is an important part of managing a leveraged trading account.

Margin coverage

Margin coverage and margin utilization are two ways of measuring current margin usage. Margin coverage allows ADSS CFD traders to see account as a percentage of used margin. This is an important metric because at 100% (where used margin is equal to the overall account value), ADSS CFD traders reach ‘warn level’, and increasing positions may be restricted. If margin coverage falls to or below 50%, positions may be closed automatically.

Margin utilization

An identical (but inverse) metric is margin utilization, that shows used margin as a percentage of account value. When margin utilization reaches 100%, increasing positions may be restricted, and at 200% they may be closed automatically.

Margin call

A margin call is a notification from your broker requiring you to deposit additional funds into your account to meet the minimum margin requirement, typically triggered when the account’s cash balance falls below a certain threshold due to losses. This can lead to forced liquidation of positions and is considered highly negative.

Initial margin

Initial margin is the amount of capital required by a broker to open a leveraged position. It is typically expressed as a percentage of the total value of the position, or a ratio. The initial margin required varies according to account type, the asset being traded, and trade size. You can find full details on initial margin requirements here.

Maintenance Margin

Maintenance margin is the minimum amount of funding required by a broker to keep a leveraged position open. If the account’s cash balance falls below this level, a margin call may be issued. Leveraged trading involves keeping a close eye on your maintenance margin and margin level to protect against margin calls before they happen.

Margin level

The Margin level is the ratio of equity to used margin in a trader’s account, expressed as a percentage or ratio. It helps keep track of how much of the deposited cash balance is being used to fund open positions. There are two closely related subterms: used margin and free margin. Used margin is the amount of capital currently tied up as collateral for open positions in a trader’s account. Free margin is what is left after used margin is subtracted from the total balance, and represents the amount of capital available in a trader’s account that can be used to open new positions or absorb losses without triggering a margin call.

Risk management in leveraged trading

The same tools and principles can be used to manage risk in leveraged trading as in normal market activities, but with increased attention paid to the funding status of your account, as well as a stronger focus on avoiding losses. The success of a strategy depends on its win rate, and the sum total of losses remaining smaller than profits from successful trades. Leverage, used correctly, can help to achieve this, but if mismanaged will increase losses. The risk management requirements of leveraged trading can be divided into two parts, one is familiar from unleveraged positions, and involves position sizing, measuring volatility, and the placement of stop losses, while the other side is specific to margin trading and involves adequately funding your account (or closing positions) to avoid margin calls. In theory, proper use of stop losses should cover margin considerations too.

Conclusion

Margin trading allows traders to control large positions, and is a requirement for strategies that profit off small market movements in relatively tranquil markets. The dangers of leverage are real, but should not be exaggerated: it is not often that sudden volatility sweeps across a previously calm market, but when it does the impact is serious. As always in the financial markets, traders need to protect themselves, first and foremost by understanding what they do and why they do it. If you can justify your positions, the direction of the trade, and the size of your position including leverage, you are well on your way to safe and effective use of leverage.

FAQs