Disadvantages of Leverage in Spread Betting
Before we turn to look at the positive impact leverage can have on your trading account and on your financial spread betting success, the drawbacks are so significant that they merit individual, up-front treatment. Without wanting to scare off new traders from what is essentially a very helpful and possibly highly lucrative trading method, spread betting’s inherent link with leverage makes it particular susceptible to the risks of leverage, and these dangers should be core to your decision making process when it comes to making calls on different trading circumstances.
Leverage is your best friend and your worst enemy at the same time. While for many, leverage is perhaps the sole reason for being attracted into spread betting in the first place, for most it is the sole reason for their departure and their inevitable financial ruin, as a result of poor decision making and lacklustre risk management. Such are the dangers of highly geared positions, they counter-intuitively represent the most consistent cause of trading failure amongst new and experienced traders alike.
Leverage is so dangerous because it bites so quickly. A position that fades by 1% following you taking your position will yield a 100% loss, in addition to the costs of your trading commission (built in to the spread). That will mean you’ve lost 2 times your original stake, maybe even more, by the time the market drops incrementally. For traders with a £10 stake, that’s a £20 loss – compare that to a loss of just 10p-20p for traders investing the same £10 in shares directly. While leverage has a corresponding effect on the other side of the fence, with profitable positions delivering quick profits, leverage continues to act against you as markets fall, with no let up or relief in the degree to which it presses and squeezes your trading capital.
Leverage is like a runaway train of momentum getting behind your trading position, and when it starts to head in the wrong direction, it can be difficult to stop. Even trades that appear on the face of them to be within the parameters of safe risk management can cause fundamental problems to your trading account, simply because of the volatility of markets and the extreme volatility of positional movements in leveraged trading styles.
Consider this example, as a means of illustrating the impact leverage can have on your trading account. A trader has available capital of £500. Forecasting a rise in the FTSE, he takes a position at £1 a point going long on the FTSE100 spread. Instead of rising, the market falls by 20 points over the lifetime of the position, resulting in a £20 loss. Overall, this loss isn’t going to break the bank, but because of the unduly high leverage hidden in the £1 a point stake, that single trade represents a 4% capital loss, which is unsustainably high and underlines that the £1 per point stake is simply too much risk to bear.
In order to cope best with the difficulties of leverage, you need to remain one-step ahead of the game. That means constantly calculating your exposure, your reserve levels and the extent of stakes you consider placing on a given market or position. A good rule of thumb for traders with accounts less than £500 is to trade at no more than 10p a point. If you can make 10 points a day on a £500 account with 10p, you will deliver a roughly 75% return on your capital over a year in a safe, comfortable trading environment.
Remember that as a result of compounding earnings, you can quickly escalate your trading position to earn returns that smash any market or investment fund without necessarily incurring the risks of overleveraged trading. Such are the advantages of trading with leverage, it can easily be possible to trade up in a low-risk, slow-and-steady-type strategy, provided you have the patience and determination to stick to your guns and see your strategy through for the long-term.