What are the risks of leveraged investing?
Of course, leveraged investing involves more risk than traditional investing where you actually buy a share. Leverage allows you to make a large investment with a relatively small amount of money. The consequence of this, however, is that every change in price has a stronger impact on the balance. If you do not yet know exactly how the leverage effect works, you can first read our informative article on the leverage effect.
Understanding leverage risks
When you invest with leverage, you do not buy the security, so you can lose your entire position if the available capital is insufficient. With a leverage of 1:20, you only need five percent of the value of the security. However, this also means that an increase or decrease in the price of $1 will be multiplied by twenty.
Before you start using leverage, it is essential to know and understand the risks. Leverage is a very useful tool and when used properly, it can result in high profits. Leverage has a two-way effect: it can help you, but it can also lead you to the abyss.
Risk of strong price movements
Leveraged products can make a volatile investment product even more volatile. Volatility indicates the movement of a share. When a share is very volatile, its price can sometimes rise or fall by several percent within a month.
If you own stocks yourself, this does not need to be a problem. If your shares fall by 10%, you can hold on to them for a long time and still make a profit at a later date.
However, when you are trading with leveraged products, a 10% drop can hit you hard. For example, if you invest with a leverage of 1:5, you immediately lose 50%. Therefore, do not invest in leveraged products without sufficient knowledge and ask yourself if you are prepared to take such risks.
Stop-loss or no stop-loss
Because of these strong possibilities to lose money, investors usually use a stop loss. With a stop loss, you can limit the loss on your investment position. However, you will lose your entire position and, as with a normal share trade, you cannot hold on to your position in the hope of making a profit at a later date.
When you trade without a stop loss, you still run the risk of losing the money in your account. This is because when the balance on your investment account is no longer sufficient, your position is automatically closed.
Risk of high costs
Investigate carefully what costs you pay as a derivatives’ trader. When you use leverage, you also pay the spread over the larger amount. For example, if your transaction costs are 0.2%, with leverage of 1:5 they can rise to 1%.
On CFDs, you also pay a financing fee, as the broker lends you the money for the investment. This means that leveraged products are really only suitable for short-term speculation.
Also, always check carefully which party is issuing the leveraged product. After all, you are not the owner of a share. If the underlying party were to collapse, you could lose a considerable amount of money. Therefore, always investigate whether the broker with whom you trade in leveraged products is reliable.
Avoiding leveraged products?
So, as an investor, should you avoid leveraged products altogether? That depends on your approach. If you like to speculate on the stock market you can use leverage on a small scale. However, it is advisable to combine this with other investment products, and you should never speculate with money you cannot afford to lose.
A different view on leverage risk
You can also look at the risk of leverage in another way. For example, if you were already planning to speculate on a stock with $5000 and to close the position at a loss of $1000, you could achieve the same effect with an investment of $1000 and a leverage of 1:5.
Applying leverage to your investments is therefore not necessarily a bad thing, as long as you think about it carefully. By applying it in the right way, you can make your investment strategy more efficient.
At some brokers it is possible to use ridiculously high levers of up to 400:1. However, this is ridiculous and your position will close quickly due to a margin call. Therefore, you should always maintain a certain margin, so the position can move. When the margin needed is for example $800, this means that the position will automatically close because of a margin call when the available capital on your trading account drops below $800.
If you want to invest responsibly in CFDs, it is highly recommended having at least 2.5 times the margin requirement available on the account. This way you avoid a margin call and the position can remain open according to your strategy. If you want to trade completely safely, it is sensible to increase this ratio even more. In this way you manage the risk of leverage.
Finally, it is important to the financing costs into account. When you invest with a leverage, you borrow money from the broker. You can read more about this in the article about the costs of investing in CFDs.