The creation of leverage in financial trading helps to facilitate the trading of global financial markets. Commodities like gold, sugar, oil, and coffee, the forever fluctuating FOREX currency pairs, and the share prices of the world’s top companies are all accessible to trade for anyone eager to trade the global markets.
This is all made possible through leverage.
So, how is this possible? Even with small initial capital, can we trade the price of the Gold, Oil, or the EUR/USD foreign exchange pair to profit from their changing prices…?
Financial contracts like Futures or Contracts for Difference (CFD’s) provide us with this opportunity. They are leveraged contracts. Leverage is the ‘risk factor’ that allows us to marginalise our trade size so that we may create larger purchasing power relative to the trading capital we have. Let’s have a look at a quick example.
The current price of EUR/USD is 1.14208
Sam believes the EUR is going to appreciate relative to the USD and wants to trade his €100 to attempt to profit from this currency appreciation. He calls his broker and invests €100 at 1.14208 using no leverage. In trading terms he is now ‘long’ the euro against the U.S. Dollar. At this point his trade is worth $114.21.
Within the next week the EUR does indeed appreciate and the EUR/USD exchange rate moves to 1.16208. His initial €100 trade in the EUR/USD is now worth $116.21. Sam decides to exit this trade, taking a $2 profit.
Leon, the savvy trader, makes the exact same trade but is very much aware that he can use leverage to help him maximise his profits from the currency move in the EUR/USD. He trades using his financial trading platform and goes ‘long’ the EUR/USD at 1.14208. In trading the CFD market he decides to leverage his trade at x 1000 using his margin in his trading account as financial collateral. As he chooses a leverage of x 1000, he is effectively trading €100,000 worth of currency at the given exchange rate.
Leon has made a nice profit. With the same exchange rate appreciation in EUR, from 1.14208 to 1.16208 he has traded with leverage to maximise his profit. In trading the CFD market he was able to trade a value of €100,000 without actually owning that capital amount itself. His profit from this trade is therefore $2,000 profit.
In trading with leverage we have greater access to ‘trading capital’ and can as a result attempt to maximise profits. However, leveraged trades do assume more risk and must be managed well with effective risk management practice. If you leverage a trade and the market moves against you, you are liable to sustain a greater loss than a trade with little or no leverage.
One key element to trading with leverage that is highly beneficial to the diversified trader is the ability to de-leverage. The best example is to consider a government bond. In the real world, the principal cost of investing in a German government 10 year bond is €100,000. This bond also has a price in relation to yield, which moves each and every day according to market sentiment. By trading in the CFD market we can actively trade the price of this government bond, again without owning the asset itself. This ability to de-leverage also provides us with access to trading equity indices and the publicly traded equities in the global financial marketplace.