Trading CFDs and Forex is largely based on the fact that brokers provide leverage to their clients. This leverage, also known as leverage in the trade, ensures that most traders are able to meet the conditions regarding a minimum trade size, which is particularly important in Forex trading. In addition, the purpose of leverage is that the customer can realize the chance of disproportionately high profits with a small capital investment. Since these high chances of profit, which are enormously increased by the leverage, are often very theoretical, we would like to present in this guide above all some calculation examples. These examples show you very well how different levers can affect the profit to be realized, but also the losses.
- General information on leverage
Brief background information: how the lever works
Before we use a few examples to explain in concrete terms how different levers work in practice, we would like – especially for new readers and beginners – to briefly go into the background and explain how the lever works. You can imagine leverage as a form of capital lending, which is usually the only way to reach the minimum trading size. In practice, depending on the broker and asset, you will often find the following levers
The higher the leverage, the more profits are multiplied, but of course losses can also be incurred when trading CFDs or Forex. Connected to the leverage is the margin, i.e. the security deposit that you must keep in the form of equity on the trading account with your Forex broker. For example, a leverage of 200:1 means that you only need to hold 0.5 percent of the total amount traded. At the same time, it also means that you will immediately make a profit of 200 percent – based on your own capital investment – if the price of the underlying asset moves in the right direction by only one percent. This high percentage profit is achieved by the leverage, because you actually make profits with capital that the broker has only lent you. Leverage does not only work in one direction, however, as it enables you to make profits with a small capital investment. On the other hand, it is of course also the case that the leverage increases the risk of losses or increases the losses. It can happen that your margin is used up very quickly, so that you may be threatened with a total loss if you cannot provide additional collateral.
Examples of leverage in Forex trading
In the following examples we would now like to explain how different levels of leverage can affect potential gains and possible losses in practice.
Example 1: Trading the Euro and Dollar currency pair with 20:1 leverage
For quite a few chunks, different levels of leverage are made available so that the customer can decide which leverage he wants to trade with. One of the relatively low levels of leverage, for example, is a leverage of 20:1, which we will use in the following example:
- Trading: Dollar against Euro
- Volume: $10,000
- Lever: 20:1
Minimum margin: 500 Euro (own capital investment)
Dollar exchange rate rise within two days: three percent
Return based on own capital employed: 60 percent
Profit: 300 Euro
In this example, with a capital investment of 500 Euros, you have achieved a return of 60 percent within only two days and thus a profit of 300 Euros. This return is still comparatively low, because with a much higher leverage your profit would have been much higher.
Example 2: Trading crude oil CFDs with a leverage of 100:1
- Trade: Crude oil CFDs
- Volume: 45.000 Euro
- Lever: 100:1
- Margin (own capital investment): 450 Euro
- Oil price increase within 14 days: eight percent
- Return on own capital: 800 percent
- Profit in Euro: 3.600 Euro
In this case the own capital investment is 450 Euro and is therefore almost identical to the margin from the first example. However, in this case, if the oil price increases by eight percent, you will achieve a significantly higher profit, which is due to the much higher leverage of 100:1 (compared to example 1). Thus, in this example you make a profit of around 3,600 Euros, although you have only invested 450 Euros of your own capital.
Example 3: Trading DAX CFDs with a leverage of 400:1
This example is intended to illustrate why CFD trading is so attractive even for small investors and speculators who simply want to try CFD trading. In this case, the capital invested is only 50 Euros, but the end result is a realistic and very high profit.
- Trading: DAX-CFDs
- Volume: 20.000 Euro
- Lever: 400:1
- Margin (own capital investment): 50 Euro
- percentage rise DAX within five hours: two percent
- Percentage return in relation to equity: 800 percent
- Profit in Euro: 400 Euro
This example is typical for the fact that with CFD trading, disproportionately high profits can be achieved even with a very low margin. The main reason for this is of course the enormous leverage of 400:1, which is not unrealistic in practice.
Example 4: Loss in trading British pound with a leverage of 200:1
In the 4th example we would like to make clear that the leverage is not only responsible for fast and disproportionately high profits, but can also be responsible for a total loss in a very short time.
- Trade: British pound against Euro
- Volume: 50,000 pounds
- Lever: 200:1
- Margin: (own capital investment): 250 Euro
- British pound falls by two percent
- Loss: 1,000 Euro (incl. additional margin)
In this example you only had to keep a margin of 0.5 percent on the trading account due to the leverage of 200:1. However, since this was a little too low for you, because the position would have been closed automatically by the CFD broker if the price had fallen by only 0.5 percent in the meantime, you had even provided four times the margin required as a precaution. Nevertheless, this security deposit was also insufficient due to the fact that the British pound lost two percent against the euro. Thus, the position in the example was closed by the broker, as there was no obligation to make additional margin. In principle, this serves to protect the trader, but nevertheless in this case it was not possible to prevent a total loss of 1,000 euros.
This example makes it clear that a high leverage can also be very dangerous, because then the minimum margin must be extremely low. However, this means that even small percentage price losses mean that the security deposit is no longer sufficient and the broker therefore automatically closes the position. The result is then often a total loss, which is ultimately mainly due to the high leverage. For this reason, experts recommend either not trading with very high leverage or at least making sure that the security deposit on the trading account is significantly higher than the minimum margin.
For example, if you trade with a leverage of 200:1, you would actually only need a minimum margin of 0.5 percent. However, you should still have a significantly higher margin of, say, five percent, because then you can cope with larger price drops in the meantime, in the sense that the position is not automatically closed. It is even more dangerous for brokers with margin requirements, because then the losses could be greater than your actual capital investment. Therefore, in such cases and especially with higher leverage, it is definitely recommended to always act with a stop loss order to limit losses. Therefore we recommend especially beginners when trading Forex and CFDs to choose a broker with no margin requirement to avoid this risk from the outset.
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