The stock exchange is not only a trading place for securities, but in some cases also a highly speculative stock market. Investors have the opportunity to make fantastic profits within a short period of time. However, they can suffer drastic losses in the same time. Due to the ever falling interest rates for investment products and the comparatively low profit opportunities with conventional shares, risk-loving investors are increasingly using speculative share transactions.
In some cases, the speculative stock market is also referred to as casino capitalism, as the highly speculative transactions no longer have anything in common with ordinary securities trading, but more with a casino. The investor no longer invests in a company and trusts its success, but rather “bets” on profits or losses. The enormous profit opportunities are provided by the so-called leverage effect.
The Fundamentals of CFD Trading
Investors can often achieve returns of up to eight percent with a conventional share purchase. You buy shares of a company on the stock exchange and hope for a rise in the price of the corresponding share.
The difference between the amount they have invested to buy the shares and the income from the sale of the shares is ultimately the profit. In order to determine the return, fees for the securities account must ultimately be deducted.
Equity trading itself is always exposed to price or currency risk. For example, the publication of a company balance sheet or the launch of a new product or even just the announcement of a new product can lead to rising or falling share prices.
If the shares are also held in foreign currencies, losses or gains can arise from the conversion into the company’s own currency. These risks are generally manageable and clearly understandable for investors.
While investors actually acquire shares in regular share trading, options offer another way of doing business on the stock exchange. With options, which are part of derivatives, investors buy the right to sell or buy a security at a certain value at a certain time.
This value refers to an underlying value of the share. In order to make a profit, this contract is based on the difference between the underlying asset and the value at the specified date. For this reason, these contracts are also called “CFDs”, “Contract for Difference”. Speculative share transactions are therefore within the scope of CFD trading, the trade with options.
CFDs are traded via so-called brokers, today simply online. Trading Crypto with leverage works based on the same principle as trading stock CFDs. Also in the case of Cryptocurrency CFD trading enables the use of leverage, but the trader won’t buy or sell the underlying asset itself. However, Bitcoin CFDs can be traded based on BTC deposits, so most Bitcoin margin traders already own BTC when they start trading with leverage on a respective crypto margin broker.
In order for an investor to exercise the right to buy or sell a share at a certain value at a certain time, he must deposit a pledge, the so-called “margin”, with a broker.
The margin is intended to ensure that the investment amount is “closed out” and thus partially secured for the broker. If a broker demands further capital to secure the purchased options, this is also called a “margin call”. This margin call occurs, for example, when the broker can already foresee that the security deposit will no longer be sufficient due to a sharp fall in prices.
When buying options, the leverage effect can now finally be used. The leverage reflects the ratio of the price of the warrant to the underlying asset. The underlying asset is also known as the underlying. With the help of leverage, it is possible to achieve high profits with little capital investment, as the money invested is multiplied. At the same time, the leverage effect can also have a negative impact on the investment, so that high losses up to a total loss are possible. Options trading with leverage is therefore very risky.
How does the Leverage work?
Leverage is best explained using an example. For example, an investor buys 100 shares in a company listed at ten euros. At the same time, he invests in options and thus acquires the right to buy 100 shares of the same company for twelve euros after one year. These call options are also called “call options”.
He pays 1.50 euros for each of these 100 options, thus investing 150 euros. These options now have a leverage of 10, which means that the investor can benefit from a rising share price, at a ratio of 1:10, relative to the share price of the company in which he has invested.
As soon as these shares have risen by ten percent after one year, i.e. to 13.20 euros, the investor has initially made a profit of 120 euros by purchasing the shares. At the same time, the leverage of ten increases the value of his option by 100 percent. The option is thus worth three euros. He can now sell his call options again on the stock exchange, generating a profit of 150 euros. He has thus made a 100 percent profit by purchasing the options.
However, the effect of the leverage can also develop in the negative direction. If the underlying value of the desired share loses five percent within a year, the value of the options falls by 50 percent. This means that the 150 euros invested in options have become only 75 euros.
In this example, the figures are still very low. You can imagine how the profits or losses would turn out if the investor had invested 150,000 euros in options with leverage ten instead of 150 euros. Here are other examples.
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Effect of the Margin
A margin of ten percent means a leverage of ten. Because leverage is calculated by dividing 100 by margin in percent. So:
Leverage = 100 ÷ 10 ÷ 100
The smaller the margin is, the more capital is ultimately moved in relation to it via the leverage effect.
Opportunities and Risks of the Leverage Effect for CFDs
The leverage effect in share transactions exerts a great fascination on investors. After all, a high profit can be achieved with a small capital investment.
But as with all equity transactions, the same applies to the use of leverage: The higher the profit potential of an investment, the higher the risk. For this reason, leveraged products are not usually referred to as capital investment, but as speculation.
- High profits possible with low investment
- Enormous yield increase possible
- Suitable for hedging existing positions
- Very high risk of loss
- Not suitable for beginners
- Not recommended for a conventional investment portfolio
- Often unpredictable, even if the investor is highly experienced