What you need to understand before making profit?
How the order is priced?
For assets that are traded on exchange, such as shares, your broker will have access to each exchange’s order book – the list of buyers and sellers currently placing orders.
The order book displays the price and size of each order, so it’s easy to see where your order should be placed.
As well as the primary exchanges, such as the London Stock Exchange or the New York Stock Exchange, there are also a number of Multilateral Trading Facilities (MTFs) which accept orders and quote prices on certain stocks. They sometimes offer better prices than the primary exchanges, although not all brokers are able to access them.
Prices offered by primary exchanges and MTFs are publicly visible, and are known as lit books. However, prices hidden in dark liquidity pools can also be available for you to trade against, if your broker has access to them. Participants in dark pools are generally institutional investors who don’t want to reveal the price, size and origin of their orders.
For OTC markets, such as forex, prices are sourced from the network of global banks and liquidity providers participating in the market.
Slippage
Another issue that can affect the price at which your order is executed is slippage.
Prices can change in a matter of milliseconds, and between the moment when you click to place an order and the point when your broker receives it, your intended price might become unavailable.
If you’re using a market order, it will be executed at the best price your broker can get. This could be substantially worse than the price you expected if markets are volatile and moving rapidly – perhaps after a startling news event or unexpectedly poor company earnings report.
You’re most likely to see the impact of slippage when you’ve left a stop-loss order to close a position in the event of an adverse market movement. Sometimes, prices may be changing so fast that it’s impossible to close your trade at the level where you set your stop.
Example
Say you take a long position on the Dow Jones Industrial Average index at 17,838 with a stop at 17,699.
A couple of influential Wall Street firms then report unexpectedly poor earnings. This causes a drop in other Dow constituent stocks, and the index tumbles through your stop. As soon as the price meets your stop level, your stop order is triggered.
Here’s a table showing how the price quoted by your broker moves in the moments before and after your stop is hit:
You can see that the bid price reaches your chosen stop level of 17,699 at 21:10:33 (in blue). This is when your stop order is triggered, but it’s executed at the next available price of 17,695 at 21:10:36 (in green). This means you have paid four points in slippage, but are protected from the rest of the price drop.
Guaranteed stops
If the risk of slippage feels a little worrying, there is an answer: you can use a guaranteed stop.
A guaranteed stop works in the same way as a standard stop-loss, except that it will always be filled at exactly the level you set. Effectively, the broker or trading provider takes on the risk of slippage for you. Naturally they may require a fee for this additional service, and this can come in the form of a wider spread.
Attaching a guaranteed stop puts an absolute limit on your potential loss, and this can be reassuring when you’re trading in volatile markets or in large sizes.
What is leverage?
When you buy an asset in the traditional way, you generally need to pay the full purchase price up front: the total value of the shares, currency, barrels of oil or whatever you’re trading. However, some providers offer the facility to trade using leverage, which means you only have to put up a fraction of the value of your position. Effectively, your provider lends you the rest of the purchase price.
This means that any profit you make, which is still based on the full value of the position, appears magnified in comparison to your outlay. The flip side of this is that any losses are magnified in the same way.
With leverage, both your profit and any loss can actually exceed your initial outlay.
How does it work?
Let’s have a look at an example to illustrate this.
Suppose you decide to buy 1000 shares in Tech Giant Inc. The share price is $1, so to open a conventional trade with a stockbroker you pay 1000 x $1 = $1000. (We’ll ignore any commission or other charges to keep this example simple.)
Alternatively, you could decide to trade using a provider that offers leverage facilities. The provider will ask you to pay just a percentage of the full $1000 to open your trade. This is known as a margin or deposit requirement, and the actual percentage will vary from asset to asset, and from provider to provider.
Say your provider has set the margin requirement for Tech Giant Inc at 10%. This means you need to pay only 10% x $1000 = $100 to open your position. You still have exposure to 1000 shares, but at a tenth of the initial cost.
Magnified profits and losses
Now let’s see what happens as your Tech Giant Inc trade progresses.
Your decision to buy these shares was shrewd as the price now climbs to $1.20. You sell to close your trade for $1.20 x 1000 = $1200, giving you a profit of $200.
Compare your profit to your initial outlay if you used conventional trading:
And now with leveraged trading:
The leveraged trade has given you a 200% profit, whereas the return for the conventional trade is just 20%.
However, take a moment to consider if, instead of rising, Tech Giant Inc had fallen by 20 cents, giving you a $200 loss. The leveraged trade would have resulted in a loss twice the size of your deposit.
It’s vital to prepare yourself for situations like this by always keeping in mind the full value of your trade, and the potential for loss, when you’re using leverage.
This is particularly true in markets such as forex, where you deal in lots that can each be worth thousands of units of currency. At the same time, margin rates can be very low.
So if you were to sell just one standard lot of 100,000 units of EUR/USD at 1.2910, the contract value would be $129,100. With a potential margin requirement of just 0.5%, your deposit for this very substantial trade would only be $645.50. It’s easy to forget how much capital is at risk when the initial outlay is so affordable.
The cost of using leverage
To keep things simple, in the examples above we’ve ignored any charges and commissions that you might pay as part of the normal trading process. It’s worth mentioning one cost that you could sometimes see when using leverage, though.
Since you don’t put up the full value of your position when you trade with leverage, this means your trading provider is effectively lending you the balance of the money. For this reason they may make a small charge to reflect their costs when you keep a trade open overnight. This is called an overnight funding charge. It varies between different products and providers, so keep an eye out for it in terms and conditions.
Margin calls
As we’ve discussed, to open a leveraged trade you need only deposit a fraction of its full value, but your losses can exceed this amount. This means that, if a position moves against you, your provider may ask you to provide additional funds to keep your trade running.
These payments are properly known as ‘variation margin’, although people usually just refer to them as ‘margin’. A request for variation margin is called a margin call.
Example
Say you buy 8000 shares at 220p using leverage. The value of your position is therefore £17,600. The provider asks for an initial margin payment of 5%, which is £880.
The share price then drops by 1p to 219p, reducing the value of your position to £17,520. The margin requirement falls to 5% x £17,520 = £876 as a result.
However, although the initial margin requirement has reduced, you now have a running loss of 1p x 8000 = £80.00 to add to this, bringing the total required to keep your position open to £956. Unless you’re already holding sufficient funds in your account to cover this, your provider will ask you to make a margin payment. If you don’t do so promptly, they may scale back or even close your position completely.
Dividend payments on short positions and funding costs are other factors that may sometimes put your account into deficit, requiring you to deposit more money. So it’s wise to remember that the initial cost of opening a position isn’t the end of the story – you may need to have more funds available to top up your account as you go.
Deciding whether to use leverage
We’ve seen that trading with leverage gives you comparatively greater profits – but also relatively larger losses. So does that make it riskier than conventional trading?
From one perspective, yes. If you commit yourself to a leveraged trade based on the affordability of the initial margin, rather than your capacity to withstand the potential losses, you’re undoubtedly playing with fire.
However, as long as you think of every position in terms of its full value and downside potential, the risk is no greater than it would be when trading directly. Your eventual profit or loss is the same – it’s only the outlay to produce it that differs.
Ways to trade with leverage
A wide range of leveraged trading products are available, covering almost every conceivable market, and many providers offer at least some degree of leverage on trades.
Most leveraged trading is done through derivative products: financial instruments that derive their value from an underlying asset. With a derivative contract you never own the underlying asset directly, but you have a financial interest in its performance.
Here are the main ways you can choose to trade with leverage:
- Spread betting (UK only)
Financial spread betting providers enable you to place a bet on the direction a market will take, rather than trading the market directly. - Contracts for difference (CFDs)
A CFD is an agreement to exchange the difference in value of a particular asset from the time at which the position is opened to the time at which it is closed. - Forex trading
You can speculate on the future value of one currency compared to another via a forex broker. - Futures
A futures contract is an agreement to buy or sell an asset at some time in the future for a particular, specified price. - Options
Options are contracts that give you the right, but not the obligation, to buy or sell an underlying asset at a fixed price on or before a certain date.