Meanings of Leverage Products

By | May 30, 2021

Leverage products enable an investor to trade underlyings with significantly lower capital than he actually has at his disposal. Leverage products include CFDs (Contracts for Difference), in German “Contracts for Difference” and forex trading (Foreign Exchange), trading in currency pairs.

  • Leverage products were strictly regulated by the EU in 2018.
  • Foreign exchange, stocks, indices and commodities are traded.
  • The risk of loss is 80 percent and more.
  • Leverage products are only suitable for very experienced traders.

How does a leverage product work?

If you look at the rates of currencies, you will see that real movements in most currency pairs occur to the third and fourth decimal places. If you want to bet on the US dollar with 1,000 euros now, you will hardly achieve any significant profit in the short term if you got your bet right.

However, if he uses the leverage of 30: 1, he can start trading with 30,000 euros, and the profit is then more attractive. The lever means that the investor does not have to raise the full 30,000 euros himself. He only provides the margin, the security deposit. The remaining sum comes from the broker. The amount of margin depends on the leverage product.

Legal requirements for the levers

In 2018, the legislature in Germany specified maximum leverage for reasons of investor protection. These are, depending on the base values:

  • 30: 1 leverage for major currency pairs = 3.33% margin
  • 20: 1 leverage for the most important indices = 5% margin
  • 10: 1 leverage for commodities (not including gold) = 10% margin
  • 5: 1 leverage for stocks = 20% margin

Less the margin for the Broker is entitled to the trader the full income from his trade. Trading in leverage products is usually closed on the day it was opened. If the trading position remains overnight, the broker charges interest.

What to look for when trading leverage products?

Leverage products involve the risk of loss. Every broker must provide information about how high the loss rates are for the trading accounts they have. The risk warning at the broker iOption reads as follows: “84.94% of retail investor accounts lose money when trading CFDs with this provider.” The Comdirect’s risk warning does not read more promising: “81% of retail investor accounts lose money when trading CFDs with this provider. ”

Choosing the right broker

Trading CFDs and Forex requires practice in interpreting a price chart and using appropriate strategies. Reputable brokers offer their customers free demo accounts and webinars or tutorials for this purpose.

One criterion for choosing a broker is the type of broker. The so-called market maker sets the prices himself and hopes that his customer loses the bet. A non-dealing desk broker or STP (Straight Through Processing) broker, on the other hand, enters the order directly into the market and only earns money from the brokerage fee.

CFD and Forex trading allow bets on rising prices (long) as well as trades on falling prices (short). CFD trading with stocks as the base value is particularly effective when stock exchanges are flagging as a price hedge for the depot.

What are the advantages of leverage products?

The two main advantages are the speed with which profits can be realized and the fact that the trader can work with a lot more money than he actually has at his disposal. Another plus point is access to many markets, such as raw materials.

Disadvantages of leverage products

The legal risk warning speaks volumes. The number of Comdirect shows that it does not depend on the broker how high the loss rate ultimately turns out to be. Serious providers, however, offer protection against total loss with the margin call, a warning message. The margin call is triggered when the negative price trend of the underlying asset reaches a certain percentage of the capital invested.

However, with the margin call it is important to pay attention to how it is structured. Some brokers apply the percentage to the total capital employed in the trade. If, for example, he has 10 trades open with an invested capital of EUR 1,000 each and the margin call is set at 20 percent, it is not triggered at EUR 200 for the trade concerned, but only at EUR 2,000. This corresponds to 20 percent of the total capital employed.

It is even more risky if the broker stipulates an obligation to make additional payments. If the trader has invested 1,000 euros with a leverage of 30: 1 and the price drops by 20 percent, he has to shoot up a loss of 5,000 euros. He had invested 1,000 euros himself.

Are there equivalent alternatives?

Direct alternatives to this type of financial betting no longer exist since the ban on binary options trading.

Classic options can be roughly compared with leverage products. The buyer of an option does not have to pay the entire purchase price for the underlying asset, but only the price for the option itself, the option premium. Only when he exercises the option is the purchase price actually due. If he does not, he has only paid the premium for the option.

The price for the option depends on, among other things

  • the current price of the underlying
  • the exercise price
  • the remaining term up to the exercise date

Another alternative in derivatives trading are futures, which are basically the same as options. The buyer of a future buys an underlying asset with a delivery date in the future, but only pays a premium today. The price for the base value is only due upon delivery.