Leveraged investment is indeed a risky business but what people may not realise is that it’s one of the best ways to build wealth.
Practically everybody is leveraged because your home, which is probably your biggest asset, is one big leveraged investment if you happen to have a mortgage on it.
When you bought your house, you probably didn’t have all the capital required to purchase it up front. No, you put up a deposit, and your bank put up the rest.
So, with just your deposit you were able to control the asset (i.e., your home) and enjoy the benefits of ownership such as not having to pay rent and increases in the price of your property. However, you do have to pay interest on the amount your bank contributed to the transaction, and eventually, you’ll have to pay them back.
Let’s say you put up a $50,000 deposit to purchase a $500,000 house. If the next day the price of the house increased to $550,000 and you could sell it immediately without any costs (wouldn’t that be nice!), you have effectively doubled your initial investment for just a 10% increase in the price of the underlying asset.
This is what financial types call “leverage”. It is the ability to control an asset with a larger value using a smaller amount of capital.
Of course, leverage works both ways. If in our example, the price of your house fell to $450,000 the next day and you had to sell immediately for some reason, you will have lost all of your equity as a result of only a 10% move against you.
On the stock market, you can also recreate leverage by using financial instruments called Contracts for Difference or CFDs.
A CFD is just a fancy name for replicating the outcome of a trade.
A trade is simply where you have a view on the future price action of an asset, and then choose to take a position in the market based upon that view.
In other words, you put some of your capital at risk if (should you get it wrong) on the basis you believe the reward is likely greater (should you get it right).
This bit is important because in any investment, the reward should be greater than the risk – otherwise why would you do it?
We all know asset prices go up and down – be it a stock like Zip Co (ASX:ZIP), an index like the Nasdaq Composite, a commodity like West Texas Crude Oil, or a cryptocurrency like Bitcoin.
There are two possible trades or positions you could make on any asset – either up or down.
We call it a “long” trade when we buy an asset on the assumption its price will rise.
In a long trade, you plan to sell the asset at a higher price sometime down the track, and if you do, the difference between your initial buy price and your eventual sell price is your profit (minus any transaction costs of course).
However, if the price of the asset is lower when you eventually sell, you’ll make a loss.
Let’s take another real life example and say you’re looking at Whitehaven Coal (ASX:WHC) around February.
There’s plenty of talk about Russia potentially invading Ukraine, and you know if it happens, it’s going to have some severe consequences for global energy supply, particularly crude oil and coal.
WHC is trading around $3, and you decide to go long a WHC CFD on a platform like ThinkMarkets’ trading platform, ThinkTrader.
Note that all of ThinkMarkets’ ASX CFDs trade around the same price as the underlying assets in their respective markets.
So, in this example, if WHC shares are offered for sale at $3 on the ASX, they will be offered at $3 on ThinkTrader.
You can magnify your wins with CFD trading
Let’s say you decide to enter a long trade on WHC using CFDs. It’s a long, so we buy first and sell later, thus we start off by buying 1,000 WHC CFDs.
Remember, CFDs are a leveraged instrument. So just like with our property example, we’re not required to put up all the capital usually required to trade in a particular amount of an underlying asset.
For each of ThinkMarkets’ ASX share CFDs, clients only need to stake or “deposit” 20% of the value of the underlying share trade – in this case the deposit would be 20% of $3,000, which is $600.
You still control 1,000 WHC share CFDs, and therefore you’ll get the benefit of any price increase (the CFD price continues to move just like the underlying share price).
You’ll even get credited the value of any dividends which are paid while you are holding the stock, but not any franking credits.
Well, in our example, our WHC purchase in mid-February at $3 turns out to be very good timing!
Europe and the USA promptly slapped a bunch of sanctions on exports of Russian coal and oil.
The market responds by pushing up coal prices and Whitehaven Coal is a major beneficiary. Its price starts to rise strongly from late-February, and by 18 July, it has doubled to $6.
If we exit our WHC CFD trade now by locating our trade in ThinkTrader and clicking the sell button, our profit is 1,000 CFDs x $3 or $3,000, less any transaction and holding costs.
A key holding cost, just like with our property example, is going to be interest. CFD trades attract interest on the value of the underlying asset traded. A typical CFD interest rate is usually approximately the same as your mortgage rate, calculated and charged daily to your CFD account.
For the most part, however, our outcome on Whitehaven is basically the same result as if we had called our regular share broker and bought and sold WHC shares in the same fashion.
The major difference is : we only had to stake $600, not $3,000 to make the trade.
Clearly, as a result our return on investment has increased significantly and that’s the power of leverage.
Be careful of the risks on CFD trading
That said, you should always consider what happens when things go wrong!
Let’s say, hypothetically, Russia didn’t invade Ukraine.
Then the EU and USA each passed a law phasing out coal fired power stations by 2030. Not good for coal prices, and not good for WHC.
Let’s pretend WHC’s price plummeted just after our purchase to $1.
Well, it wouldn’t matter whether you owned 1,000 actual WHC shares or if you had just bought 1,000 WHC CFDs, you’re going to lose some money here.
In this case your loss would be 1,000 x -$2 or -$2,000, plus any transaction and holding costs.
As mentioned before, a CFD trade simply replicates the outcome of a trade in an underlying asset.
The main difference is, how much capital you were required to stake to make the trade in the first place.
With CFD’s it’s much less, well, 80% less in the case of our WHC example.
Using CFDs to make a trade instead of the underlying shares throws up some very interesting capital and portfolio management opportunities.
Using CFDs affords investors greater spending power in the market. This allows you to use a smaller amount of capital to diversify across a greater number of investment opportunities.
Sounds sensible, right?
But as the saying goes, with great power comes great responsibility! You must be super careful with leverage.
Let’s pretend you only had $600 to invest and you did the WHC trade.
In the scenario where it went up, you would have earned 500% on your initial investment.
But there’s always a downside to anything, and there certainly is a potential downside when it comes to using leverage.
Your $600 stake is controlling the whole $3,000 worth of WHC, and therefore $3,000 not $600 is your maximum exposure.
The bottom line: Go into every CFD trade understanding the risks of leverage – because you could lose more than your initial deposit.
Protecting your downside with ThinkMarkets
The good news is, ThinkMarkets CFD offering is a bit different to many other CFD brokers.
The platform provides all its CFD clients with what it calls Negative Balance Protection.
This means the platform guarantees you cannot lose more than your initial deposit on any CFD trade – allowing you to have the peace of mind of knowing exactly what your risk is when you get into a trade.
This article was developed in collaboration with ThinkMarkets, a Stockhead advertiser at the time of publishing.
This article does not constitute financial product advice. You should consider obtaining independent advice before making any financial decisions.