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There's no reason to be afraid of leverage

LEVERAGE is often seen as a trader&rsquo;s best friend but just last week, the Japanese Financial Services Agency announced a public consultation on proposals to limit leverage on contracts for difference (CFDs). <br /><br />The regulator has suggested that leverage would be limited to five times for shares, 10 times for equity indices and 50 times for bonds on concerns that traders might over-leverage themselves in the search for profits. CFDs on commodities and precious metals would not be subject to such limits. Any restrictions would come into force from 16 November 2010, a year after the end of the consultation.<br /><br />While the UK Financial Services Authority is not expected to suggest anything so radical, at least in the near future, the potential restrictions do raise questions about leverage. While it is, of course, one of the things that makes CFDs so attractive to traders, it can also be dangerous. So how should traders use leverage, and how do you ensure that you expose yourselves just enough to the market to make it a boon, without risking too much of your capital?<br /><br />The leverage available is a function of the margin requirement, which is the amount of the money that you must have in your account in order to open a CFD position of a specific size in your chosen asset. For example, if a stock were trading at &pound;1 per share and you want exposure to 1,000 shares, then your open position would be &pound;1,000. And if the stock had a margin requirement of 5 per cent, then you would need to have &pound;50 in your account as a deposit. The leverage is the position size divided by the margin requirement, so in this case it would be 20 times. Under the Japanese proposals, the leverage would be restricted to five times, so you would need &pound;200 in your account to take out the CFD in the stock.<br /><br />Providers set their own margin requirements &ndash; and the leverage &ndash; for each underlying asset. Typically, the margin is based on the volatility of the instrument, the liquidity of the underlying market and the cost the provider faces in hedging that position. <br /><br /><strong>VOLATILE ASSETS</strong><br /><br />Normally this means that very liquid markets such as currency pairs and large cap companies have the lowest margin requirements (and the highest leverage) &ndash; GFT offers just 1 per cent on the major currency pairs. And the less liquid, more volatile assets such as small caps have the highest margin requirements. <br /><br />But this is not always the case and CFD traders should be aware that the margin requirement on their positions can change quickly. For example, at the start of this year when bank stocks were extremely volatile, CFD providers started requiring a margin of 50 per cent on positions in banks such as RBS and Lloyds Banking Group. This has now fallen back to 10 per cent. <br /><br />IG Markets recently introduced varying margin requirements for equity CFDs. According to David Jones, chief market strategist at IG, smaller positions attract the lowest margin requirement and as these positions become significantly larger, the margin requirement increases accordingly. And only the portion of your position that falls into a higher tier will be subject to the increased margin rate. This should help you manage your exposure and hopefully ensure that you don&rsquo;t end up being overexposed and at risk of losses.<br /><br />But while leverage can be your best friend &ndash; it allows you to gain exposure to an underlying asset without having the capital outlay associated with trading the physical security &ndash; it can evidently also magnify your losses should things not go your way. Thankfully, there are strategies besides stop losses that can help you reduce your risk. <br /><br />Ronnie Chopra, chief market strategist at Falcon Securities, says that one way of reducing risk when trading on these very low margins is with a pairs trade &ndash; ie, going long on one company and shorting another in the same sector. Popular pairs trades include AstraZeneca and GlaxoSmithKline or BG Group and BP. <br /><br />Chopra says: &ldquo;As long as the percentage gain is greater in the position which is long, there will be a net gain. If a long position in BG Group rises 5 per cent and a short position in BP rises 3 per cent, there is a gross gain of 2 per cent. On a 5 per cent margin that equates to a 40 per cent gain in the CFD.&rdquo;<br /><br />Clearly, leveraged CFDs give private investors the opportunity to make plenty of profit. But they can equally expose you to unlimited losses and this is clearly what the Japanese regulator is worried about. But if you are careful &ndash; and there are plenty of developments that allow you to manage your risk &ndash; then the leverage shouldn&rsquo;t wipe you out. <br /><br /><strong>CFD PROFILE STERLING-US DOLLAR</strong><br /><br /><strong>Spread:</strong> 2 basis points<br /><br /><strong>Margin Requirement:</strong> 1 per cent<br /><br /><strong>Trading hours:</strong> 24 hours<br />(information from GFT)<br /><br />Both the US dollar and sterling are weak at the moment but sterling has been having trouble getting back up towards resistance of $1.6730, especially after the dire GDP figures. Any corrective bounce is seen capped at $1.6365 but the pair remains vulnerable to disappointing US figures &ndash; note that third quarter US GDP data is out on Thursday at 12.30pm UK time and the consensus is for an annualised quarterly growth of 3.1 per cent.