Leverage explained: What is leverage in trading?

Education / 5 Min Read
Milan Cutkovic / 26 Oct 2021

Leverage is one of the most important concepts to understand when trading in the financial markets like forex, share CFDs, crypto CFDs and indices.

It’s the reason traders are able to gain full exposure to a trade and potentially see larger returns or bigger losses, despite not having the full amount of equity - something you’d need when trading traditional stocks or bonds.

Put another way, leverage makes trading more accessible by letting a trader trade more than they physically have. This happens in much the same way as someone purchasing a house by borrowing from the bank; if you can deposit a percentage of the total value, the bank will cover the difference. When applied to trading, it has you putting up a portion of the full trade amount with your broker covering the rest.

Before we deep dive in, let's understand a fundamental definition of the concept of 'leverage' in trading.

What is leverage in trading?

Leverage is a ratio representing the level of exposure you have to a trade. Using leverage means you can control trades of higher value than the margin you hold.

How does leverage work?

Suppose a trader has $1,000 in their account but feels that’s not enough to trade with. They might then opt to use the leverage provided by a broker. If they chose to use 10:1 leverage, their investment potential would turn into $10,000 (1,000 X 10). The broker will take a certain amount as margin - which varies between the different financial instruments - and essentially lend you the rest to enable you to open the position.

The benefit of leverage is that it gives traders the ability to enter and control larger funds using a small margin. This is appealing to many traders, but it is important to remember that margin trading and leverage can be a double-edged sword as they can magnify both wins and losses.

Brokers will let you adjust your leverage up or down to suit your needs, as far as 400:1 in some cases which offers some big returns from a small outlay. That can be great in theory - especially so when it comes off - but there’s another side to leverage traders must always remember: leverage not only amplifies your profits, but your losses too. So the higher the leverage, the greater the risk.

To show the relative negative impact of leverage, let’s consider a scenario whereby two traders decide to put their $10,000 of capital behind the same trade but using different leverage sizes. Unfortunately for them, the trade goes against them to the tune of 100 pips. 

  Trader X Trader Y
Trading capital (equity) $10,000 $10,000
Leverage applied 50:1 5:1
Total trade Value $50,000 $5,000
Result (Dollar value of the 100 Pip loss) -$500 -$50
Loss as a percentage of the total equity 50% 5%
Percentage of equity remaining 50% 95%

As you can see, the results for each trader are significantly different, with the higher ratio of leverage greatly amplifying the loss of Trader X - in one trade, they have wiped out half of their equity. While Trader Y still experienced a loss, the more conservative approach to leverage means that, as a percentage, there was a lesser effect on their total equity.

The obvious conclusion from the above example is that if you want to mitigate risk it’s sensible to use less leverage.

What is a leverage ratio?

Leverage ratio measures your total exposure compared to your margin. For example, if you open a trade worth $10,000 with $1,000 in available funds, you are utilising the leverage of 10:1.

10:1 leverage

What is margin in trading?

Margin is the amount of funds you need to have in your trading account in order to open a trade. To retain an open position you must also always retain sufficient margin in your account. Learn more about margin trading and review the example below.

Example 1: Calculating Margin

You have AU$10,000 in your trading account. With a margin of 1%, you’re able to open positions to a total value of $1,000,000 [$10,000 ÷ 0.01 = $1,000,000].


Let’s say you want to buy AU$500,000 (equivalent to 5 standard contracts) against the USD at an exchange rate of 0.800. Your Initial Margin requirement would be AU$5,000:


Initial Margin: 5 lots x [contract size x 0.01] = $5,000


If the Australian Dollar depreciates in value against the USD to 0.7950, your Variation Margin (unrealised loss) would be USD$2,500 (AU$3,145). You can then calculate your Total Margin requirement simply by adding the Initial Margin and Variation Margin:


Total Margin: AU$5,000 + AU$3,145 = AU$8,145


To convert this to a Margin Ratio, divide your Account Equity by the Margin Requirement:


Margin Ratio: [AU$10,000 – AU$3,145] ÷ AU$5,000 = 137%

Leverage trading example

Leverage example in the forex market

Let's assume you have $1000USD in your trading account. You identify a trading opportunity in EUR/USD and want to go long at the current market price (1.20). You place a stop loss at 1.1970 (30 pips below the market price) and set your take profit order at 1.21 (100 pips above the market price). This gives you a solid risk-to-reward ratio of 1:3.33.

The maximum you want to risk per trade is 3% of your account balance - which in this case is €30. Your stop loss is worth 30 pips and with a 0.10 Lot trade (worth $10,000) you would be risking exactly $1 per pip.

You could not open this trade with only $1000 in your account. However, let's assume you have a leverage of 50:1 on your account. The margin that would be taken from your account in that case would only be 232 USD.

Leverage example using share CFDs

Buying physical shares typically does not involve any leverage. To buy 100 shares of Apple at $150 per piece, you would need to have $15,000 in cash available (+ there would be a small commission charge). While you don't need to worry about losing more than you invested (the price of the stock cannot go into negative territory), it can take up a good chunk of your capital and deprive you of other trading opportunities.

Buying share CFDs is typically commission-free (you only pay the difference in price - i.e. spread) and you can utilise leverage.

For example, let's assume you want to buy 100 shares of Company ABC that is trading at $10. With a leverage of 5:1 at your disposal, you don't need to have $1000 in margin tied up to this position and can use the remaining capital on other trade opportunities.

Which markets offer leverage trading?

Leverage is available across almost all asset classes - from forex to commodities, share CFDs, indices, crypto CFDs, oil and precious metals.

What are the advantages of leveraged trading?

The two main advantages of leveraged trading is:

  • Increasing your profits (but can also magnify losses). Using leverage can multiply the profit on successful trades.
  • Freeing up capital. As you only need to reserve a small portion of your available balance for a particular position, you are able to utilize the rest of the free margin for other trades. Without leverage, you perhaps would not have this opportunity.

What are the disadvantages of leveraged trading?

  • Magnified losses - Leverage can increase your profit, but also magnify your losses. It is therefore important to use leverage carefully and think about the potential downside if the trade goes wrong.
  • Margin call - If you don't have enough funds in your account to cover a potential loss, your trade may be placed into “Margin Call”. If this happens, your broker is able to close your positions in order to minimise risk for both parties.

What can I do to minimise risk when trading with leverage?

1. Have a sound risk management plan in place - for example, define the maximum % of your account balance you want to risk per trade.

2. Use stop loss orders to control the maximum amount you can lose per trade. However, keep in mind that stop loss orders are not guaranteed, and in times of low liquidity, you may experience some slippage.

3. Keep your emotions in check by utilising a trading plan and keeping a trading journal. Leverage can be tempting for traders, as it allows them to control a massive position size compared to their available balance.

Can leverage cause my account to go into negative?

When you apply leverage to a trade, the potential exists to lose more than you have deposited in your trading account. In general, the greater the leverage the higher the potential returns but the higher the potential losses may be.

 

Ultimately, leverage is never something to be taken lightly. The more you use, the bigger the reward but the bigger the risk. So use your demo trading account wisely, practice with virtual funds and get a real feel for the impact of leverage.

 

Start trading today and sign up for a live trading account with Axi.

 

 

 

The information is not to be construed as a recommendation; or an offer to buy or sell; or the solicitation of an offer to buy or sell any security, financial product, or instrument; or to participate in any trading strategy. Readers should seek their own advice. Reproduction or redistribution of this information is not permitted.

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