Chapter 3




Peter Read, CEO and Founder of Pelican
Apr 18, 2018


What is leverage?



The most important difference between a Spread-bet and a traditional trade is that a Spread-bet is ‘leveraged.’ Leverage is the mechanism of borrowing funds in order to amplify potential returns. However, it must be remembered that leverage on a trade which is not going in the predicted direction can amplify potential losses.





This is best explained through the analogy of purchasing a house. Imagine that there are two investors, Jack & Jill. Each have £20,000 in savings and both want to invest in property. Jill decides to take out a mortgage of £80,000 to supplement her deposit of £20,000, thereby giving her the ability to purchase a £100,000 house. Jack by contrast is more risk averse and decides not to take out a mortgage. As a result he buys a flat for £20,000. Over the next three years the market rises by 20% and both Jack and Jill decide to sell up. Jill sells her house for £120,000 and returns the £80,000 mortgage to the bank leaving her with a profit of £20,000 or 100% (£120,000 - £80,000 = £40,000. £40,000 minus Jill’s original £20,000 gives a profit of £20,000). Jack sells his flat for the same 20% increase for £24,000, netting a £4,000 profit or 20% on his original investment. Clearly Jill has profited handsomely from borrowing in this instance. The same process applies when using a spread-bet as each contract is leveraged.





Offering leverage makes trading certain markets feasible, such as foreign exchange. At the time of writing this article, Revolut is quoting a price of 1.1465 to convert £ into €, giving  €1,146.5 if £1,000 is converted. If the £ should then rise by 10 ‘pips’ against the € over the next 24 hours to €1.1455 then the €1,146.5 could be converted back to £1,000.87, or a profit of £0.87 - hardly worth it.





Now imagine that the £1,000 is used as a deposit to borrow £99,000 then the exchange would result in €114,650. Following the same trade would deliver a £87 profit at the end of the day. This is the power of leverage, but don’t forget that it greatly amplifies losses if your trade moves in the other direction to what you initially thought it would.

Leverage amounts differ across markets. CfD contracts for the major currency pairs are often highly leveraged. Some unregulated businesses will push leverage of upto 500 times, which is irresponsibly large. By contrast leverage of shares are typically low; somewhere between 5 and 20 times.


Stakes and margin



Spread-bets work by entering the stake size the trader is prepared to win or lose per pip or point moved. This, coupled with the leverage rate for the given trade, determines the margin (deposit) required. The following screenshot illustrates this.





The screenshot shows that this trade is in BP.
That it is long (buy) trade. i.e. the trader thinks the price will rise.

The stake size of £1 per point. So the trade will profit by £1 for every point it moves. In this case, if the underlying share price of BP rises by 1 pence, the trader will be winning £1 (remember if it goes down by 1 penny, the trader will be losing £1).

The margin required to make this trade is £28.51

This means that the leverage is £508.26 = (£1 * 536.636) - £28.51. This equates to roughly 19 times leverage (536.636 / 28.51)




 











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Your capital is at risk. Losses can exceed deposits when trading CFDs or spread betting.



Spread betting and CFD trading are leveraged products and as such carry a high level of risk to your capital which can result in losses greater than your initial deposit. These products may not be suitable for all investors. CFDs are not suitable for pension building and income. Ensure you fully understand all risks involved and seek independent advice if necessary.
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