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Introduction to leverage

4.5-minute read

One of the main features of CFD and forex trading is the ability to utilise leverage. But before you get started, it's worth learning exactly how leverage and margin work.

What is leverage?

Leverage is a tool used by traders that enables you to control a large amount of capital by putting down a much smaller amount. Unlike traditional investing, where you must pay for the full value of your position upfront, with leveraged trading you only have to pay a deposit known as your margin.

In the case of 50:1 leverage, for example, you can use £1 to control a position worth £50.

Leverage has opened markets such as forex and commodities to more retail traders, who don't want to allocate large amounts of capital to each position. However, it will magnify the profits and losses from any trade, so should be used with caution.

What is margin?

Margin is the capital that you'll have to put down to open a leveraged trade. Different markets will have different margin requirements. You might have to pay 20% of the full value of a shares position, for example – while you could only have to put down 5% with FX.

CFD trading is a popular way of accessing leverage when buying and selling shares, indices, forex and more. Let's examine how it works in practice.

Leverage example: share trading vs CFDs

Share investing

You buy 1,000 shares in company XYZ, with a share price of 250p.

The value of your trade is £2500. You're buying shares outright, so you have to pay the full amount upfront.

Profit

If company XYZ's share price rises to 260p, then you can sell your shares for £2600 – earning you a £100 profit.

You've made £100 from £2500, a return of 4%.

Loss

But what if XYZ's share price fell to 240p? You'd lose £100, or a 4% loss.

Share CFDs

You buy 1,000 share CFDs in company XYZ, with a share price of 250p.

CFDs in company XYZ have a margin requirement of 20%, so you only have to pay £500 to open.

Profit

If company XYZ's share price rises to 260p, then you can sell your CFDs to realise a £100 gain.

You've made £100 from £500, a profit of 20%.

Loss

You'd still lose £100 on the CFD trade – but because you only put down £500, that equates to a 20% loss.

As you can see in the above example, margin will multiply both your profits and your losses. Because of this, using orders as part of a comprehensive risk management plan is crucial when using leverage. We'll cover this in more detail in the Strategies and risk course.

Margin calls

You'll always need to ensure that you have enough margin in your account to cover the cost of your open trades. If you don't, then you could quickly find yourself on a margin call, which means your positions will be at risk of being closed out.

If you drop below 50% of your margin requirement, your position will be closed automatically.

Returning to our example, say that company XYZ's share price drops to 220p. Your running loss from the trade would be £300, which would mean that you have less than half of the £500 required to maintain your position. At this point, you'd be at risk of seeing it get automatically closed.

This is to prevent your losses from becoming too large.

If you get placed onto a margin call, we'll let you know via email. At this point, you have three options:

  1. Close out your position
  2. Reduce the size of your trade to free up some equity in your account
  3. Add additional funds to your account to cover the shortfall in margin plus additional funds to sustain any further losses

If you leave your position and it drops to 50% of margin, we'll close it automatically.

Leverage costs

As with standard investing, you'll have to pay to open a leveraged trade – via either commission or the spread. When you pay via the spread, the costs of your trade are incorporated into the bid and ask prices. With commission, they are separate.

You'll also pay borrowing costs on positions that you keep open for more than a single day. This is called overnight financing.

Overnight financing is essentially an interest payment to cover the cost of your leverage. At FOREX.com, we charge 2.5% above or below SONIA (or an equivalent interest rate), depending on whether you have a long or short position open.

On positions with no expiry, overnight financing will be charged each day that your trade is open. With forwards, the cost of financing is already incorporated into the spread, so you don't have to pay each day.

Calculating overnight financing

To calculate overnight financing on a long position, you take its size at the end of the day and multiply it by SONIA plus 2.5%. Then you divide that figure by 365 to get a daily rate.

Did you know? You don't have to calculate the financing charge manually whenever you trade. On the FOREX.com platform, you can see the overnight financing charge for any market by looking at the Market 360 tab.

Example of calculating overnight financing

Say you own 1000 CFDs at 450p at the end of the trading day and SONIA is 3%.

  1. Your position is worth £4500
  2. SONIA + 2.5% = 5.5%
  3. 5.5% of £4500 = £247.50
  4. £247.50 / 365 = 68p

When shorting, meanwhile, the calculation is the same – except that you minus 2.5% off SONIA instead of adding it. Your account may be credited with the overnight financing fee, depending on interest rates.

Example of calculating overnight financing when shorting

  1. Your position is worth £4500
  2. SONIA - 2.5% = 0.5%
  3. 0.5% of £4500 = £22.50
  4. £22.50 / 365 = 6p

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Test your knowledge

Question 1 of 3
You want to trade $100,000 of AUD/USD, which requires you to pay 5% as margin. How much margin do you need to put down?
  • A $5000
  • B $50,000
  • C $500
Question 2 of 3
AUD/USD moves up and you close your position, earning you $8000 profit from your $5000 margin. What is your return on investment?
  • A 12.5%
  • B 8%
  • C 160%
Question 3 of 3
If AUD/USD had fallen and lost you $4000, what would your total return be?
  • A -20%
  • B -80%
  • C -5%