Presentation and function of the leverage effect:
Let us first take a few minutes to examine exactly what is a leverage effect, what is its purpose and particularities.
A leverage effect is used for investing in the stock markets with the aim of being able to invest more capital than is actually held by the investor. With a leverage effect an investor has the opportunity of multiplying their positions, sometimes even by 1,000 times the actual value of their capital. Of course, these exceeding high leverage effects are reserved for professional investors. Individual investors are authorised to use lower leverage effects due to the risks their activities may incur.
To summarise, a leverage effect is a means offered by brokers to enable investors to trade with higher volumes than those the client really possesses if they were to use their own trading capital. This leverage therefore enables them to access markets that would otherwise be inaccessible.
We shall now continue to the actual function of the leverage effect. A leverage effect has the objective of placing higher orders than the actual deposit completed. We could compare the leverage effect to a credit granted by the broker that enables traders to trade more than they truly hold on their investment trading accounts. The objective here of course is to generate more profits when there is a small difference in the rates of the asset, but the potential losses are also greatly magnified in the case of a faulty prediction. This is why the new legislation is so strict relating to the use of this leverage effect. It is in fact recommended to be extremely prudent when taking position on an asset using a leverage effect.
To make this leverage effect possible it is necessary to understand the notion of margins. In fact, part of your capital is rendered immobile when you open a position on the markets. This is the margin. The remainder of the funds necessary at the opening of your position are in fact advanced by the broker or financial intermediary. The total amount of the sum invested is therefore not blocked on your trading account.
If the operation of the leverage effect may still seem complicated to understand, we advise you test this function using a demonstration account in real time conditions to comprehend the risks it entails.
The advantages and disadvantages of the leverage effect:
Of course, the leverage effect function offered by the online brokers provides certain advantages but also significant disadvantages that you should be aware of before using it.
Concerning the advantages of this leverage effect, we of course particularly note the fact that this tool enables you to speculate on the markets with higher funds than the capital you actually possess. As indicated earlier, this therefore has the advantage of allowing users to access certain markets they would not normally be in a position to do so.
Of course, the leverage effect, in the case of a correct prediction of an asset’s price movement, will enable you to generate higher profits than without a leverage effect. We can therefore say that, in a winning position, the returns on an investment are increased with a leverage effect.
Let us now pass on to the major disadvantages related to the use of the leverage effect on the stock markets. We particularly note that this leverage will significantly increase the risks related to your investments by considerably increasing potential losses. Therefore, in the case of a faulty prediction of a price movement of the chosen asset, the return ratio of your investment is highly reduced.
Regarding this differing information, we note here that the leverage effect can be advantageous, but it is also extremely risky. It is therefore absolutely vital to use it with the greatest prudence. Remember that in effect the use of this tool does have inherent risks and can potentially lead to a total loss of your capital that you have invested in a relatively short amount of time, notably if you use a high leverage effect. This is why, generally speaking, the leverage effect is a tool that is reserved for more experienced traders.
What are the legal limits for leverage effects according to ESMA regulations?
In August 2018 the European regulatory authority, the ESMA or European Securities and Markets Authority published strict rules relating to the use of leverage effects for individual investors. These regulations have the objective of best protecting the investors against the risks inherent in high leverage effects due to the high volatility of certain assets.
Therefore if you wish to use a leverage effect in Europe then the maximum leverage effects available are as follows:
- For the Forex market the maximum leverage is 1:30 with a margin of 3.33% for the major currencies.
- The CFDs for indices, gold and minor currency pairs on the Forex offer a maximum leverage effect of 1:20 with a required margin of 5%.
- The other CFDs for commodities offer a maximum leverage effect of 1:20 with a 5% margin.
- The CFDs for shares and other similar assets offer a maximum leverage effect of 1:5 with a 20% margin.
- Finally, the CFDs on crypto currencies offer a maximum leverage effect of 1:2 with a 50% margin.
It should also be remembered that before this decision was taken by the ESMA, in Europe, the leverage effect was unlimited and only the brokers made decisions relating to the levels that they offered to their users. However, this is no longer possible as the maximum leverage effect for individual investors is only 1:30, and even this is for only certain assets. As we indicated earlier, professional clients are the only traders that have the possibility of using a higher leverage effect but only if the broker with whom they complete their transactions grants them professional status. These regulations only concern transactions completed in Europe of course and not in other areas around the world that follow different regulations. It should be noted that the AMF, which is the French regulatory authority for financial markets, has also imposed a limited risk account to brokers with a reduced leverage effect.