What is Leverage in Trading? Everything You Need to Know
What Does Leverage Mean in Trading? Leverage is the use of borrowed funds from a broker to amplify your trading… Continue reading What is Leverage in Trading? Everything You Need to Know
What Does Leverage Mean in Trading?
Leverage is the use of borrowed funds from a broker to amplify your trading position beyond your own capital. For instance, leverage can allow you to multiply your position by 10x, 20x, or even 100x, enhancing your market exposure.
Regular trading involves using only your deposited funds to speculate on price movements, while leverage trading means most of the capital is provided by the broker. You only need to place a margin deposit, which is typically a fraction of the full position value.
📍 Example: Opening a forex position worth $2,000 may only require a $100 deposit with a 20x leverage ratio, where your broker provides the remaining $1,900.
🔍 How Does Leverage Trading Work?
Leverage trading works by requiring the trader to put down a deposit known as a margin, which makes them eligible for increased exposure on a trade. Simply put, with leverage you only need to put a fraction of your position’s value to open a trade but your return or losses are calculated based onthe trade’s full value, not the margin.
For example, if you intend to buy 1000 shares of Tesla at the price of 100 cents on a regular trade account, your broker would require you to pay 1000 x 100 cents for exposure of $1000 minus commission and other fees. But with leverage, you can pay a fraction of this cost upfront. So, if the margin trading amount was 20%, you’d pay $200 to open the position. However, your returns and losses would be calculated on the full $1000.
If, for example, you opened a long trade and Tesla’s stock price rises by 40 cents, your 1000 shares are now worth 140 cents each. When you exit the position, the outcome would be that you doubled your margin amount of $200 and received $400.
If Tesla’s stock price fell by 40 cents, you will make a $400 loss, still double your initial margin. In essence, the losses or returns are greater than your margin amount in this example.
📈 Example:
- Position Size: $1,000 for 1,000 shares at $1 each
- Margin Requirement: 20% or $200 deposit
- Profit/Loss Calculation: If share prices rise by $0.40, the profit would be $400, doubling the initial margin.
However, losses can also double, demonstrating the risks of leverage.
🔢 What is Ratio in Leveraged Trading?
Ratio or leverage ratio is a measurement of your trade's total exposure compared to its margin requirement. The ratio amplifies your trading power and shows how much your trade size is magnified as a result of the margin held by the broker.
It indicates the relationship between the trading capital and the total value of the position you are controlling.
Ratio in leverage trading is expressed as a fraction, for example, 1:100. The numerator represents the money being invested while the denominator represents the total value of the position you control.
This means that for every $1 you invest, you would control a position worth $100.
The higher the ratio, the higher the position size you control.
| Leverage Ratio | Explanation |
|---|---|
| 1:100 | Control $100 worth of assets for every $1 invested. |
| Meaning | Shows how magnified your trade size is via broker-held margin. |
Higher ratios mean larger positions, but also increased risk.
🌍 What Financial Products and Markets Allow Leverage Trading?
Leverage trading is not available for all markets and assets. The availability of leverage may depend on the underlying asset or specific market. This is because several factors such as market liquidity, brokerage policies, regulatory restrictions, and asset types can affect its availability.
Leveraged trading is more common in markets or assets with high liquidity because this ensures that there are a lot of traders to facilitate transactions. There are low chances for leverage trading including on markets/assets that are characterized by extreme volatility, low levels of liquidity, and major fundamental risks.
However, several financial markets support leverage trading as listed below:
Forex Market
The forex market is one of the most popular markets for leveraged trading as it offers a wide range of currency pairs and high liquidity.
The forex market allows high leverage ratios like 1:500 or more. This makes it perfect for experienced traders who can take advantage of market movements but are able to appropriately manage risks.
Futures Market
Futures contracts are agreements to trade a specific asset at a predetermined price on a future date.
With the futures market, leverages are built into the contract itself, this enables traders to control larger positions than their initial investment.
In most cases, the leverage ratio for futures contracts is determined by the platform.
Also, traders are often required to deposit a percentage of the contract value (margin) as a security deposit.
If the trader's account balance falls below the required maintenance margin, they will receive a margin call, informing them to deposit additional funds to maintain their position.
Failure to meet a margin call can result in the liquidation of the position.
Options Market
Assets on the Options market have embedded leverage. This means that if you do not borrow funds from your broker to trade Options you would still have levered exposure to the underlying asset.
For instance, say it costs $2349 to buy an ounce of gold. With Options, you can use $32, which is only 1.37% of the amount to buy an October call option on an ounce of gold.
So if gold rises to $2500 by October, a long position with gold gives you ($2500 - $2340) / $2340 = 7% in gains. But with a call Option, you get ($2500 - $2340 - $32) / 32 which is a 400% return.
However, if the price of gold does not rise by October you'll get a 0% return holding gold but a -100% return on your call option position. So like any leveraged position, the call option amplifies your gains and losses.
Margin Accounts
Margin Accounts are brokerage accounts that allow traders to borrow funds from the broker to purchase securities. The borrowed funds often provide leverage which enables traders to control larger positions.
In most cases, the leverage ratio in margin accounts is determined by the broker and can vary depending on the type of securities being traded.
| Market | Description |
|---|---|
| 📊 Forex Market | Popular for high leverage ratios (1:500+), suitable for experienced traders who manage risk. |
| 📉 Futures Market | Contracts include leverage, often requiring margins to maintain positions. |
| 📈 Options Market | Embedded leverage provides exposure without direct borrowing from brokers. |
| 💳 Margin Accounts | Brokerage accounts allowing borrowed funds to control larger trades, ratio varies by broker. |
✅ Pros and Risks of Trading with Leverage
📈 Pros
Leverage trading offers traders several benefits especially if the trader is experienced and has proper risk management strategies. Below are some advantages of leverage trading:
- Increased Buying Power: Leverage trading increases the traders’ buying power and enables them to trade more assets than they could with their own funds alone.
This increased buying power enables traders to open bigger positions.
- Hedging Strategies: Leverage can also be used to hedge or protect existing positions against potential losses. While this is complex, it comes in handy when you want to minimize the risks of an open position.
| Benefit | Explanation |
|---|---|
| 🔄 Increased Buying Power | Open larger positions than possible with your own funds alone. |
| 🛡️ Hedging Strategies | Use leverage to protect open positions against adverse price movements. |
📉 Cons
Leverage trading is risky and is not recommended for inexperienced traders.
- Amplified Risk of Trading Capital Loss: The risk of losing your trading capital is high with leverage trading. An adverse price movement can devastate your trading capital especially if you don't have risk management measures in place.
- Margin Calls: Margin calls are often made when your account balance falls below a certain level due to loss. Margin calls require you to deposit additional funds to maintain your position. Failure to do so often results in the liquidation of your position. This is often done at an unfavorable price.
- Stress: Leverage trading can be emotionally draining and stressful due to increased exposure to loss. Stress in trading is often catastrophic as it results in impulsive decisions that can jeopardize your trading position.
| Risk | Explanation |
|---|---|
| ❗ Amplified Risk | Losses can exceed your initial margin, making leveraged trading risky for inexperienced traders. |
| 📉 Margin Calls | Brokers may require additional funds if your balance drops below a threshold, risking position liquidation. |
| 🧠 Emotional & Mental Stress | Increased exposure can lead to stress, resulting in impulsive, risky decisions. |
🛡️ How to Manage Risk in Leverage Trading
Forex trading with leverage is risky as losses can exceed your margin, but you can use risk management tools like Stop Loss orders, Guaranteed Stops, and Negative Balance Protection to reduce potential loss.
With Stop Loss if the price of the underlying asset moves against you, the trade will be closed at the price you’ve set. Guaranteed Stops work the same as Stop Loss but ensure that the exit point does not exceed the price you set, irrespective of volatility.
Negative balance protection means that if your balance goes to negative, the broker will push it back to zero without charging you.
Effective risk management is crucial when trading with leverage. Here are some recommended tools:
| Tool | Description |
|---|---|
| 🛑 Stop Loss Orders | Automatically close positions to limit losses if the market moves against you. |
| 📉 Guaranteed Stops | Ensure trades close at the set price despite market volatility, avoiding slippage. |
| 🛡️ Negative Balance Protection | Prevents your account from going below zero, resetting it without extra charges. |
🏁 Conclusion
Leverage in trading allows you to increase your position size which reduces the initial investment required. However, it amplifies potential losses or returns as you can lose your entire initial capital. So, it is important to include risk management tools like stop loss in your trading strategy when using leverage. Plus, go for a broker that offers Negative Balance Protection.
❓ FAQ
| Question | Answer |
|---|---|
| What does 1:500 leverage mean? | 1:500 leverage means that the trader must pay 1/500th of the value of the deal while borrowing the remaining.. |
| What leverage is good for $100? | For a balance of $100, leverage lower than 1:10 is recommended. |
| What is a good leverage for beginners? | Beginners should start with the lowest leverage possible as this will help limit losses. |
| What leverage is good for gold? | There is no best leverage for Gold. The right leverage depends on your trading strategy and experience. |
Tip: Always apply careful risk management strategies to avoid substantial losses when trading with leverage.