If you are relatively new to capital market trading, you might not be aware of leverage. This is a concept that allows you to enhance your returns by borrowing money from your broker to trade specific products. Leverage is a great tool if used properly. You can significantly enhance your returns by increasing the position size you employ on each trade. You need to use leverage in conjunction with strong risk management as leverage cuts both ways and you can lose more than you expect if you are not careful.
How Does Leverage Work
Leverage works in conjunction with a margin account. This type of account allows your broker to lend you capital that you can use to invest in specific trading products. One of the more popular products that employs leverage is a contract for differences (CFD). A contract for differences tracks the movement of an underlying asset but does not require that you purchase the asset.
A contract for difference allows you to purchase a tracking asset without posting all the capital needed to purchase the underlying asset. For example, you can purchase Apple shares as CFDs by only posting 20% of the money needed to buy a share of Apple. So, if Apple is trading $170 per share, you only need to post $34 to buy 1 CFD on Apple shares. Your broker will lend you the additional money needed to purchase 80% of the capital needed to purchase 1-share of Apple stock which is embedded in the Apple CFD.
Are There Any New Regulations on CFDs?
In 2018, the European Market Securities Authority established new regulations on specific securities including CFDs if you trade with leverage. The regulatory authority was cracking down on the leverage that brokers provide retail clients. The reason was two-fold. The first was to protect retail clients from taking trades that could be too risky. The second was to avoid systemic risk that could topple retail brokers if an unexpected movement in the market occurs. An example was the decoupling of the EUR/CHF which put many retail forex brokers out of business.
What are the New Leverage Limits in the Eurozone?
The new leverage limits installed in 2018 provided retail clients with a range of leverage from 30-1 to 2-1, which varied according to the underlying volatility of the asset. For example, currencies have the lowest volatility and the highest leverage, whereby crypto currencies have the highest volatility and the lowest available leverage.
Major currency pairs have the highest available leverage at 30-1. This means you can borrow up to $30 for every dollar you have in equity. Non-major currency pairs as well as gold and major indices provide leverage up to 20-1. Commodities other than gold such as oil and silver have leverage levels up to 10-1. Equity shares which can have significant volatility can have leverage on CFDs of up to 5-1. Cryptocurrencies which have the highest volatility have leverage of up to 2-1.