Disadvantages of Leverage
The advantages of leverage are enough to make even the most experienced trader’s mouth water. The appeal of massive gains from seemingly minimal capital exposure, and the sheer volatility with which positions transpire in CFDs makes it an exciting world in which to do business. Trouble is, real life isn’t always as smooth as it may appear in theory. In fact, there have been growing calls amongst regulators internationally looking to clamp down on the less savvy consumer investment end of the market, with a view to curbing the rise in ‘mum and dad’ traders investing their life savings without a thorough understanding of the ins and outs of this complex and potentially highly risky investment strategy.
Whether you’re a high flying professional trader with years of experience or you’re a complete novice looking to make a quick return on your money, being conscious of the degree of severity of the risks posed by leverage is key to developing a robust risk management approach, and as a result is absolutely fundamental to your success when playing the markets.
The first and arguably most significant disadvantage with leverage is the inverse of its main advantage. When things are going well and the markets are going your way, leverage is a fantastic tool to have on your side, propping up your earnings and increasing the speed of your returns. For maximising your gains from each trade, there isn’t really anything better than massive leverage giving you the benefit of greater buying power. However, when markets and positions start to move against you, things can become pretty difficult pretty quickly with leverage turning against you to cause potentially extensive damage to your trading portfolio.
As leverage moves strongly in your favour, it also moves in equal strength against you when you call a position incorrectly, and both earnings and losses are as equally unlimited. Consider the following example.
Buying CFDs on corn, you assume the market will rise over the course of the day following an upcoming announcement anticipated to show weaker production than last year. For a £50 investment, you take £1000 worth of leveraged exposure to corn, in the hope that prices will rise on the day. But when the figures are released, production has flat lined on the year, surpassing what many had anticipated as being a weak crop. This has a knock-on effect on pricing because supply has remained constant rather than fallen, leading to the widespread selling of corn with speculators looking to cut their potential losses. As an aside, this is the point where you should seriously be looking at offloading your exposure as quickly as possible in order to take a small loss – a small premature loss is far better than a massive loss on a position when it is fully realised.
With corn prices falling by 10% on the day, your position has gone from being worth £1000 to now being worth £900. While this represents a 10% drop on the transaction’s value, it will have devastating implications for the trader.
The £1000 leverage amount still has to be repaid in full to the broker when the position is settled, including any outstanding financing costs. But the position now yields a £100 loss – that’s 200% down on the initial investment of £50. When multiplied over a number of positions across your portfolio, the speed and ruthlessness of leverage in chopping down the value of your positions is what makes it such a dangerous beast.
Aside from the risks posed by leverage in terms of amplifying losses to a greater extent, highly leveraged CFDs are also disadvantages with the passing of time, as a result of the way leverage is charged to traders. Holding a leveraged position overnight attracts a financing cost on the total size of the transaction, expressed as a percentage, and this is payable on every single position held overnight on a daily basis. While the percentages might not seem substantial, they are much more significant when calculated as a percentage of the initial capital deposit.
For example, assume the daily financing charge for a leveraged position is 0.03%. 0.03% on a position worth £1000 is equal to £0.30 per day. However, when that £1000 is actually composed of just £50 in capital, £0.30 becomes 0.6% of your capital exposure, applied as a daily expense. Hold the position for a week, and you’ve paid 4.2% – that’s a 4.2% higher hurdle to overcome towards making a profit. While this is by no means impossible, the higher trading costs associated with funding leveraged positions make calculating the risks and thinking through your trading strategies a must if you’re looking to trade profitably. When coupled with the increased risk profile of trading on margin, this adds up to make leverage a concept that can’t be taken likely.