Financial leverage (sometimes called gearing) multiplies your financial lifting power.
Spread betting allows you to be involved with financial trading with much less capital outlay than if you were to buy and sell stocks – this is because trades are leveraged. As opposed to physically buying the underlying shares, spread traders speculate on the movement of the stock price. In particular, as a percentage of that stake, movements can be considerable; either positive or negative. In fact, spreadbets are often said to provide you the most ‘bang for your buck’ by being leveraged. Leverage or gearing as it is something called is the idea that with a relatively modest outlay you can make big profits or losses.
If you’re speculating with financial instruments such as spreadbets then you are most likely leveraged. Leverage involves utilising borrowed money or financial derivatives such as spread betting or CFDs so as to magnify investment returns. This means that transactions require modest amounts of money to be put down to take a reasonably large position. In practice it means that to get a spread bet exposure value of a £10,000 investment, the spread betting provider might request you to ‘put up’ only £1000 as an initial margin deposit on your bet and will effectively lend you the remaining £9,000. Similar to a mortgage company, the spread betting firm will charge you interest on the £9,000 it has notionally lent you, which takes the form of an overnight ‘rolling’ charge (however in the current low interest environment this works well).
“A 10x leveraged investment makes you ten times poorer if it goes wrong and ten times richer if it goes right. High leverage in this instance is the enemy of the retail punter. Also, in general the bigger your trade size, the less leverage offered by the broker
You are still exposed to the £10,000 investment exposure should things move against you, but if the market moves in the correct direction, then you’ll never need to deposit the additional £9,000 which in the interim could be utilised elsewhere (say to open additional positions thus diversifying your speculative investment or simply left in the bank earning interest).
Do note that leverage is a double-edged sword as it equally amplifies your losses as well as your gains. Thus, if there is an adverse price movement leverage will also magnify the trading losses. Let’s take a house mortgage example to illustrate the principle. For instance, if you bought a £500,000 house using a £100,000 deposit you’re leveraged by a factor of 5x. Were property prices to fall by 20% ‘on paper’ your house would now be worth £400,000 translating into a £100,000 loss in its value, and thereby your deposit investment has notionally been wiped out entirely.
“Since profits and losses can be magnified using small initial cash deposits (margin), discipline is necessary if you wish to avoid your account balance suffering a boom or bust. Overconfidence, or ‘conviction’, leads margin traders to ignore any evidence that contradicts their opinion of a market.”
Similarly, by using spreadbets or CFDs, you can have a 10 fold exposure to the rise or fall in a stock price. So if the stock price rises by 10%, you have effectively doubled your money. However, this also works in reverse, should the price fall by 10%, then you would a 100% loss of your initial margin deposit. Even more serious, falls in excess of 10% would not only wipe out your initial capital but would also lead to a margin call (demands for cash).
Suppose you had £1,000 in risk capital. Let’s say you were thinking of placing a £10-per-point spreadbet on a share priced at 100p. If a spread betting provider had you leveraged 10x so that you had actually risked £10,000, then indeed a 10% price fall would wipe out your £1,000 stake (conversely a 10% price rise would double your £1,000 stake). So, as you can see it is wise to use leverage conservatively and say, instead of betting £10-per-point you would bet £1-per-point for a notional risk of £100 on the 100p share. You would then be exposed to your intended £1,000 worth of purchasing power (10x leverage), but a 10% price fall would only take you down by £100.
“This process is very similar in workings to buying a house using a mortgage loan. In the worst-case scenario, you would stand to lose your entire investment in the house, but the whole mortgage would still be outstanding, not only the deposit that you originally put down when buying the house.”
Thus, as you can see the cost of potentially higher returns from utilising leverage is the higher risk that comes from such investments. A traditional investor who only buys shares on margin would experience extraordinary returns in raging bull periods which would help him multiply his original investment; in bad years it would leave him licking his wounds. Spread betting and CFDs on the other hand allow you to take advantage of both bull and bear market cycles how do beware that they are still margin traded instruments; which means that they are geared or leveraged products which still multiply your directional opinion of an instrument.
And beware. Leverage also works in reverse and can wipe out a margin deposit fast! This is why it is never a good idea to leverage yourself to the tilt. That’s also the reason stop losses are a good idea for spread traders looking to limit their downside risk. Stop losses and guaranteed stops in particular help to put a ceiling on losses which is a great feature to have. Also, as you can see above leveraged trading doesn’t mean that it is inherently more risky, the leverage merely serves as a multiplying factor – the problems stems from the fact that most investors tend to use too much leverage.
The leverage means even a small initial investment could have the potential to return a sizable profit. You can open a £10,000 exposure to a FTSE listed company like British Airways with just a £500 initial deposit in your spread betting account. A 10% increase in the share price would then translate into a profit of £1,000. Additionally, since spread betting trades are made on margin, this makes it possible to target much smaller price movements.
“Leverage can be your friend or your foe. Leverage allows for superior risk-management and the ability to more practically trade with smaller account balances when utilised properly; alternatively, when leverage is not used responsibly, the results can be catastrophic, yielding results similar to lottery tickets.“Theoretically you can treat your spread betting account like your share dealing one – taking relatively small, leveraged trades of the stocks you wish to hold in your shares portfolio in your spread betting account, whilst keeping the bulk of your monies in cash to offset the maintenance costs of leveraging up your positions. This allows you to ‘replicate’ a normal stock portfolio without incurring a tax gain (or loss).”
One practical way to utilise leverage would be to give yourself the ability to diversify your risk across multiple open spread trades – that way you don’t end up with an all-or-nothing punt on one particular market going in your favour. In practice, however, you don’t really need to worry about leverage that much in my opinion – concentrate on keeping the % of your account risked on a trade to an appropriate minimum and leverage will take care of itself. Many investors are put off from spread betting because of the large potential losses. However, there are several ways to become a spread trader without any of the sleepless nights… For instance with a spread betting account of £10,000 it would be a good idea not to risk more than £500 on any one trade. More on risk control mechanisms such as money management and stop losses in their respective sections.
Of course the psychology of 10x leverage is difficult. If I trade a 16 stock portfolio of £6000 per stock on £100k total capital each initial trade sets me back with an immediate loss of around £150 (depending on spread). If I do the same with 10x leverage it sets me back £1500. So scaling in with just four stocks sets me back £6000 in drawdown. The greater the leverage, the greater the drawdown at the start of the trade and the greater the stop needs to be in £ terms. So, the unleveraged 10% stop would be £600 per trade while the 10x leveraged stop would be £6000.
To conclude while leverage can be a great advantage, it must be treated with respect and approached cautiously because at the end of the day you are using a smaller deposit amount to give you a greater exposure to the market, so it’s prudent to have your contingencies in place. Make sure you fully research and understand the risks involved. Would-be traders would do well to open a demo trading account to familiarise themselves with all order types and place some trades to ensure they understand how the markets move. When progressing to a live account, you should be disciplined in selecting an appropriate trade size while applying stop-losses to all trades and ensuring that your strategy is always to cut losing trades early while letting profits run.
“Spread betting is an ideal stepping stone into the world of futures trading and most spread betting firms allow you the ability to water down leverage to comfortable levels, unlike (real) futures which are fixed. However, position sizing (or bet size) needs to be matched to risk preferences and objectives. In fact position sizing is one of the most important techniques that successful traders use to achieve their objectives.”