How do leveraged trades work?

Here's why you should never use leverage.

I have never used leveraged trades on eToro, but I have been wondering how they work. In this post, I will explain what I have figured out. I hope this will be useful for you and I will be grateful if you can fill me in on what I am missing.

A leveraged trade is where you borrow money from the broker to trade on the market. You need to provide a part of the capital needed for the trade, which is known as the margin. The rest of the amount needed is provided by the broker. The broker generally enforces a stop loss at 50% of the margin that you have paid. As you approach the stop loss you will receive a margin call from the broker, asking you to add more margin to the trade to reduce the stop loss. If you fail to do so, your trade will be closed at a loss.

Now let's break this down with a simple example.

Let's say you think $NSDQ100 is going to crash. You have $1000 but you want to bet big! You leverage your $1000 to borrow $9000 from the broker and short the $NSDQ100 with the $10000. Now you must pay back the money you've borrowed your broker in full, plus the fees. So you would have to incur any loss on the trade. That means if the index goes up 1% viz. $100, that $100 goes from your capital of $1000 and translates to a loss of 10% for you. This is why the trade is called a 10x leveraged trade. Conversely, if the index goes down 1% you would profit 10%.

Let's see how much fees you would pay on such a leveraged trade. I tried with my virtual account to short $NSDQ100 with 10x leverage using $1000 and here is the breakdown of the fees.

• Spread = $3.1

• Overnight Fees = -$0.12 (refund)

• Weekend Fees = -$0.35 (refund)

I was surprised to see that instead of charging me money to use leverage, eToro is offering me a refund! Just to have the full picture, here is the fee if I was buying with 10x leverage.

• Spread = $3.1

• Overnight Fees = $2.65

• Weekend Fees = $7.96

I have to pay a large fee to buy with leverage, but shorting is free?! What's going on? What's really happening is that these are actually CFD (Contract for Difference) trades and not actual trades on the market. eToro need not actually buy the asset on your behalf, it is only a contract where you and eToro have agreed to pay the difference and settle the trade. So in a way, when you are buying a CFD you are betting against the broker. So in this case, the broker is incentivizing you to short the index, but doesn't want you to buy the index, which means the broker expects the index to go up.

Notice that the spread you are paying is for the $10000 trade, not just the $1000 trade, and you would pay the spread twice once to buy and once to sell. So this means if I hold this position for 1 week, I would end up paying the following amount in fees.

($3.1 * 2) + (-$0.12 * 5) + (-$0.35) = $5.25

or, about 0.5% of your capital.

For a leveraged buy position, you'd have paid the following fee.

($3.1 * 2) + ($2.65 * 5) + ($7.96) = $27.41

or, about 2.74% of your capital.

The stop loss is mandated by eToro to 50%. Which means the index only has to fall 5% for me to hit my stop loss. I opened the trade at $20654.55 and the stop loss was set at $21687.26.

As the index approaches the stop loss, I may decide to increase the stop loss. To do so, I would have to add more funds to the position to increase the margin. I tried increasing the stop loss by $1000 to $22687.26 and I had to add additionally $484.12 to my margin, but surprisingly the number of units didn't change. Do now when the index goes down by 5%, I don't really gain 50% on my capital, I only gain 33.68% on the total capital I have invested in the position.

This means that if the index keeps going up I have to keep adding capital with diminishing returns just to keep the trade open.

What I haven't yet figured out is how this works for copiers. In theory, copiers should simply mirror the PI portfolio, but suppose a PI is forced to add funds to the account to increase margin. The copiers are unable to add funds simultaneously and their portfolios don't sync immediately. In this case, the leveraged position will remain open for the PI but not for the copier. This is only my hypothesis and I haven't been able to verify this.

Conclusion:

• Leveraged trades are mostly CFD trades in which you are essentially betting against the broker. The broker is able to cover up their risks with transaction fees. Remember, the house always wins.

• In many cases you are paying very high fees to use leveraged trades.

• You may be forced to close your leveraged trades at a loss if you cannot fulfill the margin calls.

• Adding funds to a loss making leveraged trade diminishes returns.

I write educational posts to help new investors learn. If you find my post helpful please like, comment and share them. This helps me achieve higher visibility.

Consider copying me on eToro @gauravk_in if you appreciate my common sense investing approach and honest and transparent communication style.