Leverage in Trading: How it Works

Leverage is one of the most popular and prominent trading tools today, but using it to your advantage requires a larger understanding than what most inexperienced traders drawn to its promise of high rewards have.

What Is Leverage in Trading?

In essence, leverage is a financial tool which enables you to borrow funds from a broker in order to gain the ability to control larger market positions with a much smaller initial deposit, also known as margin.

This deposit then acts as a collateral, while the broker covers the rest of the value of a position, allowing you to significantly amplify any potential gains, while also opening you up for equally magnified losses.

How Leverage Works

As we mentioned, leverage works on the principle of margin trading, and the leverage ratio set by a broker for the trading instrument of your choice is what determines the multiplier effect

For example, a 2:1 leverage on a $100 deposit will allow you to control $200 of market exposure. Let’s say a broker has set this leverage for trading gold, and you want to buy an ounce priced at $1,000. 

With this leverage, you would need to deposit a margin of $500 to trade with an ounce. If the leverage was 10:1, you would only need to deposit $100 for the same level of exposure.

Let’s say you put up that $500 margin on a 2:1 leverage, and the price of gold increases to $1,100 per ounce. Your profit is everything above the initial price position, or $100 in this case, representing 20% of the margin. 

The same rule applies to losses, as a price decrease to $900 would lead you to a $100 loss in this scenario.

Leverage Ratios Across Markets

As you parse through different stock trading platforms, you’ll notice that different brokers offer different ratio levels, and that the ratios vary widely depending on the underlying asset that’s being traded.

The ratio level will also depend on the broker’s policies, market regulation, liquidity and volatility, among other factors.

For example, the highly liquid Forex market usually features the highest leverage ratios, while the extremely volatile cryptocurrency market has the lowest ratios possible.

Indices and commodities stand somewhere in the middle, while stocks and ETFs usually have slightly higher leverage ratios than crypto.

Benefits and Risks of Leverage in Trading

Besides the obvious potential for high profits, leverage eases the entry barrier to the markets we mentioned, as they might require more capital than a large number of traders have. 

Trading with leverage also helps with portfolio diversification, as it can allow you to put your funds into multiple traders which could be out of your reach if your capital is limited.

Another benefit is the ability to hedge investments, as you can, for example, use leveraged short positions to mitigate risks during market downturns by offsetting losses in a long-term portfolio.

When it comes to risks, there are some things besides the amplified potential for loss that you should be aware of. The biggest risk here is the complete loss of your initial margin, or even a margin call from the broker.

Margin calls occur when your account balance drops below the minimum margin requirement set by the broker, which may then lead to the broker closing the positions to prevent further losses if you cannot put enough funds in your account to keep the trade open, in a process otherwise known as liquidation. 

Another big risk is overleveraging, or going for quick profits with extremely high leverage, which can lead to catastrophic losses, and emotional decisions which can completely destroy your capital.

Lastly, if you hold leveraged positions open overnight, many brokers will charge you a fee, often referred to as rollover or overnight financing fees, which vary from broker to broker and can erode profits over time.

Leverage and Risk Management

As you can see, managing risk is essential when trading with leverage. If you are new to this form of trading, we suggest you first start with assets that have lower ratios, like stocks or ETFs, and test out trading with a leverage of, let’s say 5:1, in order to minimize risk while you get your footing.

Another crucial thing is to implement stop-loss orders, which will automatically close your position if the market moves against it by the amount you predetermine, for example 5% below the position’s entry price. This practice can greatly limit potential losses and ensure they are at least manageable.

You should also regularly monitor your positions and stay informed about market conditions, especially in volatile periods where you might need to adjust your strategies on time in order to mitigate losses.

Of course, having a more diversified portfolio is a recommendation that anyone experienced in trading will always give you. In this case, we would point out the importance of position sizing techniques, where you can allocate a specific size to each position in your portfolio to ensure that one single position can’t impact your portfolio’s health.

Before committing to live trading, you can also test out your strategies and refine your trading approach through demo accounts or paper trading platforms that are now widely available on the market.

When you do trade with real money, make sure not to get complacent and always be prepared to learn more about the market dynamics, analyze it through technical and fundamental analysis and always make sure to trade without making emotional decisions, which often happens when trading with high leverage.

In Conclusion

With extremely high profit potential, and an equally serious level of risk to your capital, trading with leverage is something that only the most experienced traders should seriously consider. For those that are just starting and learning, we’d advise that you always start slow, do not over leverage or trade with money that you cannot afford to lose.