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So you want to start trading on leverage. But what exactly is it and what do you need to know? For example, how can such a method of trading enhance your portfolio, how to minimise market risk or hedge your portfolio, and more.
What is leverage?
When you trade on leverage, you’re trading on a smaller margin to increase your position beyond what you have. You would need to put up a certain margin, which is a percentage of the total amount you’re borrowing from a broker.
If the margin is 1% (also expressed as 100:1) and your total transaction value is $100,000, then you’ll need to put up $1,000 as the margin (you’re borrowing the rest from the broker). This is helpful because you are still able to trade/control much larger amounts, even if you don’t have that actual amount on hand.
You can gain and lose
Just so you know, while you can potentially control much larger trades using leverage, things can go either way — your gains and your losses will be magnified.
Assuming someone trading on leverage does not bother to set a limit (a pre-determined price where you want the trade to be executed). The underlying asset that you’re tracking swings in your favour and you make a big profit; the converse might happen too, where it swings unfavourably and you make a loss that might be way more than the margin you put down.
The good news: There are risk management tools to help you mitigate your losses, which we’ll get to later.
Here are 5 key things you should know if you’re entering the world of leveraged trading:
1. Helps you maximise your capital on hand
As mentioned above, trading on leverage means you can trade on margin. This can be helpful, as one only needs a fraction of the total amount needed to carry out a leveraged trade (not everyone has $100,000 lying around, but we’re more likely to have $1,000).
The lever analogy
It’s called leverage because it’s like a lever (for those of you who studied physics in school). A lever enables a small force on one end to be translated into a much larger force that can lift a heavy weight on the other end.
The small force is your margin, and it’s lifting the large force, which is the total transaction value borrowed from the broker.
Trading on leverage with IG’s KOs
One such platform that offers leveraged trading is IG, in particular its latest product, Knock-Out CFD or KO. KOs have an in-built risk management tool akin to a guaranteed stop, which lets you determine your maximum risk level to protect you from market volatility (we’ll get to that in Point 3).
KOs are essentially a Contract for Difference (CFD) product with a knock-out level — where a CFD is the difference in price at the start and at the end of a trade. And IG is one of the first CFD brokers to offer KOs in Singapore.
Here’s how a typical trade using IG’s KOs might look like, with the Straits Times Index (STI) as the underlying asset:
The market moves in your favour and you close the trade at 3185 and profit.
As you’ll get the margin for the knock-out premium back (it wasn’t activated), the final balance into your trading account is S$250 as your profit is less than the margin you paid.
2. You can find opportunities in both a bear/bear market
You might also be wondering why in the example above, we specified a “Bull KO”. That’s because when you buy KOs, you can select if you want to buy a Bull KO or a Bear KO — where when you buy a Bull KO, you predict that the underlying asset will increase in value, and Bear KO if you expect the underlying asset to decrease in value (you’re shorting the trade).
Being able to buy both Bull or Bear KOs could be useful in a volatile market situation. While those who buy plain vanilla assets might see numbers in the red, you could use Bear KOs to your advantage and potentially turn that into a tidy profit.
Why am I able to “long” or “short” the market with KOs?
Because KOs are essentially CFDs with added risk management, you’re buying the difference in price movements. If you go long, it means you’re first buying at a lower price and selling at a higher price in hope that markets go up — straightforward, right?
If you go short, it’s a bit trickier. You’re first agreeing to sell what you don’t have (yet) at a certain price (usually current value). If all goes well, the price drops and you’re able to buy the asset at a lower price to fulfil the order/contract. That’s when you can turn a profit by short selling (which is what happened with GameStop).
3. Product that comes with attached risk management tools
Gapping or slippage is what happens when the price at which your order is executed does not match the price at which it was requested.
This is due to the market moving against your trade during the time taken for your broker to process the order — and this could happen in a volatile market situation where sudden large movements could happen before anyone can react (yes, even experienced traders).
Thankfully, there’s a way to cut your losses when gapping/slippage happens. Earlier we illustrated an example where you pay a margin when trading KOs and that margin paid is your maximum loss. This means, even if the market moves way past your KO level, you don’t lose more than anticipated.
That’s the beauty of risk management tools available with IG’s KO product (probably more than what typical leveraged products have)… and there’s more:
- Removal of emotions from your trades: Your knock-out level is immovable after you place your trade so you won’t be emotionally swayed by market movements and keep changing the stop level
- More risk management: Traders are also able to set additional stops (before their KO level) that acts like another level of protection
- Limits on trades: Traders can also set a limit to sell at a specific price (who knows when the market might suddenly go crazy — it’s better to make a humble profit than to lose your entire margin)
Using the same example as above, here’s another scenario:
Trading using IG’s KOs — limiting loss (with STI as the underlying asset)
If you attach a limit to this trade to close before the KO level is reached, at say, 3160, you will get the margin ($250) for the KO premium back (the KO premium is only paid if the KO level is triggered).
4. There’s access to thousands of markets
Leveraged trading is available on thousands of markets from commodities, indices, FX, shares etc, giving you plenty of options to access opportunities in the financial markets. If you want to access markets 24/7, you can also trade 24-hour indices (for example, IG’s KOs allow you to go long or short on over 80 indices markets).
Indices, or the plural of index, are a measurement of the price performance of a group of shares from an exchange. For example, in Singapore we have the Straits Times Index (STI), a market capitalisation weighted index that tracks the performance of the top 30 companies listed on the Singapore Stock Exchange or SGX.
5. Leveraged trading gives you the ability to hedge your portfolio
Because of the nature of CFDs, you’ll have the ability to hedge your portfolio, or limit the risk in your current investment (i.e. you build a hedge on your property to limit the number of intruders). For example, you can buy a USD/JPY CFD and if you feel that the value that will fall, you can place a Bear KO on the same underlying asset, making sure to set additional stops and limits on both, to hedge against sudden volatility.
While this might affect your potential profits, hedging your portfolio could also reduce your losses (although KOs themselves already greatly help with limiting your maximum loss).
To find out more about alternatives to FX trading, check out IG’s free ebook, which also includes a chapter on Knock-Outs.
The information in this article is meant for informational purposes only and should not be relied upon as financial advice. Users may wish to approach a financial advisor before relying on any advice provided by the website to make any decision to buy, sell or hold any investment product. Contracts for Difference (CFDs) are speculative products. The leveraged nature of CFDs involves the risk of losing substantially more than your initial investment.
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