It is important that before you consider using leverage to trade with, that you understand the risks involved and how adding leverage to you trading plan will effect the investment.

Two examples of using leverage/margin to trade

Regular shares

After opening a margin account you would be required to make an initial deposit, which can range from $2,000 to $5,000 and up depending on the broker. This initial deposit also called the minimum amount sets your starting point for trading. If you deposited $2,000, you would have $4,000 of buying power (your $2,000, plus $2,000 from the broker).

You can margin up to 50% of a stock’s price in most cases. For example, if you wanted to buy 100 shares of a stock selling for $20 per share for a total of $2,000, you could margin $1,000 of the purchase price. In other words, you would use $1,000 of your money, known as the initial margin, and the broker would loan you $1,000.
In this example, if the share price was to increase to $25 per share with the total value now being $2500; this would give you a $500 profit on your $1000 investment. As this was the actual investment on your part. His would represent a 50% return on investment before fees.
An example of using leverage to purchase CFDs

When trading using leverage you are asked to deposit a small percentage of the overall cost that would otherwise be required if you were to purchase the equivalent shares in the physical market.

Even though your outlay is small in comparison to the equivalent physical trade, you will still be exposed to the same potential profit and loss. This means your Return on Investment is magnified.

Calculating your initial margin requirement using a Share CFD example
The amount required to place a leveraged trade is known as your initial margin requirement.
You wish to buy a 2,000 Share CFDs at $5.00
The Share CFD has a 3% margin requirement
2000 x $5.00 = $10,000.00 (this is the total value of the position)

$10,000.00 x 3% = $300.00
Your initial margin requirement for this trading position is $300.00 excluding other charges such as commissions and exchange fees.
If the share value was to increase to $5.50, the total value of the shares would be $11,000. Based on the initial margin of $300; this represents a 333% return on investment.

So, you see in both examples trading with leverage can greatly increase your market exposure and potential profits. However, always back test your trading plan first and if in doubt, don’t leverage.

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Roy Masters is a technical writer for Masterful Trading.com.