Hi Traders, I'm Luke from Disciplined Trader.
This video is part of the trading basics series and in this one we are going to look at leveraged
trading.
We will discuss what leveraged trading is exactly, how it works and the two different
types of leveraged trading accounts you can open.
The first thing I want to do is demonstrate how an unleveraged trade may work.
Lets say for example you have an account of £1000 and want to buy shares in ABC Ltd.
The current share price is £100.
So using your £1000, you can buy 10 shares, which you decide to do.
Two weeks later, the share price now sits at £102.
You sell your 10 shares and realise a profit of £20.
From your £1000 investment, you have made a return of £20 which equates to a 2% return
on investment.
If you were to make that same trade with a leveraged account, your return on investment
would be increased.
Let me demonstrate why.
As before, you have £1000 in your account and want to buy shares in ABC Ltd.
The share price as before, is £100.
However, this time your broker is enabling you to leverage your account.
This essentially gives you more buying power with the money you have as the broker only
requires a deposit to open a position, that deposit will only be a fraction of the actual
trade cost.
This deposit is called the Margin.
The margin requirement will vary from broker to broker and market to market.
Let's say in our example, the margin requirement is 20% (it's much smaller on a lot of markets
in reality).
This would mean that our broker would only require a deposit of £200 for the same 10
shares.
Two weeks later, the share price has risen to £102 as it did in the previous example
and you sell your shares.
Now you have made £20 from £200 invested which is equivalent to a 10% return on investment.
Now you may be thinking, okay but I still only made £20? and that's true, but the difference
is you still had £800 of your £1000 available.
You could have invested £500 of your account in the leveraged trade, this would have bought
25 shares at £100 which you would have then sold at £102 two weeks later for a return
of £50.
That is still a 10% return on investment, but £30 more than you made on the unleveraged
trade by only using half of your account!
Hopefully that has demonstrated how powerful trading with leverage can be.
Obviously there are risks that come with trading with leverage.
In the same way leverage can amplify your profits, it can just as easily amplify your
losses.
Hence why, as we have already covered in in this series, having a solid risk management
strategy is so important.
Before we move on to the trading accounts that use leverage, I just want to cover leverage
and margin in a bit more detail so you fully understand it.
Leveraged trading (also know as trading on margin) is borrowing power afforded to you
by your broker.
This can be anything from 2:1 to 500:1 although there are limits on this depending on what
country you are in.
Here in the UK for example, this is capped to 30:1 for retail traders.
In example we just looked at, we used 5:1 leverage.
Margin is the amount of money you need to open a leveraged trade, this will be a percentage
of the total trade value.
In the example we just looked at, the margin was 20%.
We could have worked this out from the leverage by dividing the total trade cost by the factor
of leverage we were using.
The total trade cost was £1000 and the leverage factor was 5, this gives us £200.
£200 as a percentage of £1000 is 20%.
When you open a trade, the margin amount isn't removed from your account, more kept to one
side (you may see this described as blocked funds or something similar) whilst the trade
is open.
Maintenance margin is the amount of money needed to cover any current losses on the
position (if there is any).
This will usually be the other funds in you account.
If the losses on an open position start to get to the point where they could exceed the
margin and maintenance margin, your broker will issue you with a margin call.
Which essentially means you need to either top up the account with more funds to cover
the open position or close the position and realise the loss.
They do this as leveraged trading does enable you to lose more money on a trade than you
have in your account.
Going back to our previous ABC Ltd examples, if on the unleveraged trade the price instead
fell to £40 from £100 and you sold at £40.
You would receive £400 from the sale of your 10 shares and would have lost £600.
This is fine from the brokers point of view as they didn't have any shared exposure in
that trade, all the money was put up by yourself.
In the leveraged example, You bought 25 shares in ABC Ltd with 5:1 leverage from the broker.
The margin for the trade is £500 so this is kept to one side by the broker, leaving
£500 spare in your account.
If the price then fell to £40 as in the previous example, your trade would have lost £1500
so your broker would have issued you with a margin call long before the price reached
this level, informing you that you needed to add more money to your account otherwise
the trade would be closed for you.
So how can you utilise leverage?
Well there are two main account types that you can open, either a spread betting account
or a CFD account.
These account types trade derivative markets.
A derivative market is a market that follows the price movement of an underlying instrument
or asset.
You can trade these markets without ever owning the instrument or asset and it's for this
reason we are able to utilise leverage on these accounts.
An example of this with the broker I use would be the UK100.
This market is a derivative of the FTSE100.
It follows the price movement of the FTSE100 but when I trade this market, I never actually
own any of the underlying asset.
Both accounts types use leverage but have small differences so lets look at each in
detail.
(it's worth mentioning here that I am not a financial advisor and this should not be
considered financial advice.
You should do your own research before opening and trading an account).
Spread betting is a leveraged account type that is classified as gambling here in the
UK (you may want to check the classification if you are based elsewhere).
This means that any profits made via this account are tax free as the UK does not tax
any profits made from gambling.
You enter positions on this account type by essentially making a bet as to whether the
market you are trading is going to go up or down.
Your bet is a specified amount of money per point/pip.
For example, lets say you thought the GBP/USD currency pair was going to rise, you could
enter a long position at £10 per pip.
This means that for every pip that currency pair moves up, you make £10.
Equally for every pip the pair moves down, you lose £10.
A CFD (or contract for difference) account works in a very similar way but is not classified
as gambling.
Therefore any profits made on this account type are taxable.
However, losses can be offset against profits for tax purposes.
Essentially with this account type you are agreeing to exchange the difference in price
on a market from the point the contract is started to the point it is closed.
Because trading a single entity on markets isn't really viable as you would make barely
any money, positions are quoted in standard lot sizes which vary in size from market to
market.
Currency markets for example, a standard lot would be 100,000 units.
Whereas a standard lot would be equivalent to 100 shares on the stock market.
Often these lot sizes are then broken down into micro, mini and standard sizes.
Again looking at the forex market, a micro lot would be equivalent to 1000 units of the
currency, mini would be 10,000 and a standard would be 100,000.
Because trades are structured in this way, calculating your position size can be slightly
more difficult.
However, there are position size calculators available on the internet for free, such as
this one on the Baby Pips website - I'll put the link to this one in the description below.
Simply enter the details of your trade into the calculator and it will tell you what lot
size you need to trade.
And that wraps up this video on leveraged trading.
I hope you found it useful.
If you enjoyed the video, please feel free to leave a like on it.
If you have any questions or want me to cover any other topics in future videos, please
let me know in the comments below.
Also subscribe to the channel for more videos like this one.
I will be continuing this trading basics series to provide new traders with all the knowledge
they need to get started.
Thank you very much for watching and I hope you all have a good trading week.