Leverage trading: a comprehensive guide to strategies and risks
Have you ever bought a house with a mortgage? You would need to provide a small downpayment, say 10% of the house’s value, while the bank lends you the remaining 90%. Let’s say, you purchase a home for $100,000. You put in $10,000 and the bank pays $90,000. The price of the house goes up by 10% ($10,000) and you decide to sell. You return $90,000 to the bank and you’re left with $20,000. This means your profit is 100% since you contributed only 10% of the money, even though the house only appreciated 10%. If the house value drops by 10% and you sell, you’ve effectively lost your entire downpayment.
This is similar to what happens while using leverage in trading. Your downpayment is the margin and the loan of funds from the broker is the leverage. When prices move in your favour, any gain is magnified; but if prices move against you, your losses can increase just as quickly. In that case, you may receive a margin call from your broker, asking you to add funds or close positions. This is why leverage trading is called a double-edged sword. It can magnify profits but also amplify losses.
What is leverage trading?
Leverage trading involves using borrowed capital from a broker to increase the size of a trading position beyond what would be possible with only your available funds. Imagine you want to buy 100 shares of a stock, but you only have enough cash for 10. With leverage, a broker will lend you the remaining capital, allowing you to open a much larger position than your initial investment would permit.
The primary distinction often lies between leverage and trading with margin. While closely related and often used interchangeably, leverage refers to the ratio of the total value of the position to the actual capital required. Margin is the amount of your own capital that you must deposit with the broker to open and maintain a leveraged position. Margin acts as collateral for the borrowed funds.
Leverage can be used in trading almost any asset, including stocks, forex, commodities and cryptocurrencies via derivative instruments like contracts for difference (CFDs).
How does leverage work?
Let’s say you want to use leverage in forex trading to open a position worth $3,000 in the EUR/USD with 1:30 leverage (the maximum for major forex pairs under retail trading rules). You’ll only need to put up $100 of your own capital as margin, while the remaining $2,900 will be funded by the broker.
Now, let’s say the price moves up by 10 pips to 1.1010. For a $3,000 position, the pip value will be $0.30 ($3,000 x 0.0001). So, your profit will be $3 ($0.30 x 10 pips). This means a 3% gain on the $100 you invested of your own funds. If the price were to drop by 10 pips, your loss would also be $3. This shows how leverage amplifies your gains or losses relative to your initial capital.
Understanding margin requirements is crucial. The minimum margin depends on the leverage ratio you use. In this example, to open a position worth $3,000 with 1:30 leverage, you must maintain a minimum margin of $100 in your trading account. If your position moves against you and your funds fall below this level, you’ll receive a margin call from your broker.
A margin call is a request to deposit additional funds in your trading account. If you don’t meet the margin call, your broker may automatically close your leveraged position to prevent your account from going into a negative balance and protect both you and the broker from potential losses.
What is a leverage ratio?
Leverage ratio shows the relationship between the total value of the position you control and the amount of your own capital you’ve invested. It’s expressed as a ratio, as mentioned above. Here’s how to calculate it:
The effect of leverage on potential profits and losses is direct and proportional. With 30:1 leverage, a 1% price move in your favour would translate into a 30% gain on your initial margin. Conversely, a 1% move against you would result in a 30% loss of your margin.
It’s also important to understand the difference between margin and full exposure. When you use leverage, your full exposure is the total value of the position you control ($3,000 in this example). Your margin is the smaller amount you provide ($100). Many new traders focus only on their margin, forgetting the much larger exposure they’re taking on.
Benefits of leverage trading
Despite its inherent risks, leverage trading offers several benefits when used prudently.
One of the most prominent advantages is amplified potential returns. As demonstrated earlier, even a small favourable price move in a leveraged position can translate into substantial profits. This magnification of gains is the primary allure of leverage.
Another key benefit is the small capital required to open large positions. Without leverage, accessing certain markets or taking meaningful positions might be too expensive for many retail traders. Leverage lowers barriers to entry, enabling traders with limited capital to participate in the markets.
Since leverage is available via derivative instruments like CFDs, they allow you to trade both rising and falling markets. So, you can go long if you expect a price increase or open a short position if your analysis signals an impending price decline. This is particularly useful in volatile markets where prices can swing significantly in either direction.
Finally, leverage can help with portfolio diversification. Since less capital is needed for each position, you can allocate funds across a wider range of assets. This can help spread risk and potentially capture opportunities in different sectors. For example, you could diversify by opening small leveraged positions in forex, crypto and stock CFDs, rather than being limited to a single unleveraged stock purchase.
Risks of leverage trading
While the benefits of leverage trading can be appealing, it’s important to remember that it also amplifies potential losses. The risks linked to leveraged trading can be significant and may result in substantial losses if not managed carefully.
The main risk is magnified losses. Since leverage increases your market exposure, even a small adverse price movement can cause a notable loss relative to your margin. For example, with 1:30 leverage, a 1% move against your position would lead to a 30% loss of your initial margin. This shows how quickly capital can decline when trades move unfavourably.
Unfavourable market moves can also lead to margin calls and liquidation. If your account balance falls below the required margin and you don’t add funds, your broker may automatically close your open positions to prevent your account from going into a negative balance. This can result in the loss of your invested funds.
Another key risk of trading with leverage is overtrading. The appeal of higher potential returns can tempt traders to take on too much exposure or open multiple positions at once. This often leads to emotional decision-making and unnecessary losses. Leveraged positions can also be stressful to manage, especially during volatile market conditions.
High volatility can cause markets to move sharply in a short time. Even when using modest leverage, sudden price swings can trigger margin calls or forced closures. That’s why it’s crucial to understand how leverage works and to practise risk management—ideally on a demo account—before trading with real funds.
Open a demo account and practise leverage trading with zero risk.
How to manage risk when using leverage
Effective risk management is indispensable in leverage trading.
One of the most fundamental risk management tools is the stop-loss order. A stop-loss is an instruction to your broker to automatically close your position if the price falls to a predetermined level. By setting a stop-loss, you define your maximum acceptable loss on a trade, preventing further losses if the market continues to move unfavourably. However, in fast-moving markets or during periods of high volatility, your stop-loss level may not be met exactly due to slippage or price gaps, meaning the order could be executed at a different price.
A more advanced form of stop-loss is using guaranteed stops. Unlike regular stop-loss orders, which can be subject to slippage, a guaranteed stop ensures your trade is closed at the exact price you specify, regardless of market gaps or volatility. Please note that Capital.com charges a small fee for using guaranteed stops.
Brokers are required by regulation to provide negative balance protection to retail clients. This means you cannot lose more money than you have in your trading account. If a sudden price move leads to losses exceeding your account balance, the broker must cover the shortfall, preventing your account from going into the negative. This is a crucial safety net, especially in highly volatile markets.
Setting leverage limits is another way to manage trading risk. Just because a broker offers 1:30 leverage doesn’t mean you should use it. Prudent traders choose leverage based on their risk tolerance.
Finally, choose your position size wisely. This involves calculating the appropriate size of your trade based on your total account capital and your defined risk per trade. For example, if you want to risk no more than 1% of your account per trade, calculate the maximum position size that would result in a 1% loss if your stop-loss is hit. Disciplined leverage trading strategies can help manage your exposure so that no single trade disproportionately affects your overall capital.
Leverage trading strategies
Carefully chosen leverage, combined with well-defined trading strategies, can lower risk.
Swing trading
This strategy involves capturing short-to-medium term price movements, typically holding positions for a few days to a few weeks. Swing traders can use leverage to capitalise on price swings, aiming at capturing profits from relatively small price moves.
Scalping with tight stops
Scalpers aim to profit from minute price changes, often holding positions for mere seconds or minutes. High leverage trading allows them to target meaningful profits from the accumulation of tiny gains through the day. Consider placing tight stops here, as positions are held for very short durations. Even a slight adverse move can quickly negate potential profits or lead to significant losses.
Hedging strategies
Hedging involves opening a position to offset the risk of an existing position. For instance, if you hold a portfolio of physical stocks and anticipate a short-term market downturn, you could open a leveraged short position in a stock index CFD. The profits from the short CFD position could help offset potential losses in your long stock portfolio. This strategy uses leverage not for aggressive profit-seeking, but for risk mitigation.
Risk-reward ratio optimisation
Before entering a trade, define your target profit (reward) and maximum acceptable loss (risk). A common practice is to aim for a risk-reward ratio of 1:2 or 1:3, meaning you expect to gain at least twice or three times what you are risking. Since leverage amplifies both sides, maintaining a favourable risk-reward ratio is critical.
Combining leverage with technical indicators
Traders often use indicators like the Moving Average Convergence Divergence (MACD) to identify momentum and trend changes, or the Relative Strength Index (RSI) to spot overbought/oversold conditions. Bollinger Bands are useful in determining volatility while the Stochastic Oscillator is a popular momentum indicator.
High vs low leverage trading
This is a critical decision that significantly impacts your risk exposure and potential gains. The optimal choice often depends on your experience, risk tolerance and trading style.
High leverage trading offers the advantage of maximising potential returns from small price moves. However, if the market moves unfavourably, the losses will also be substantial.
High leverage necessitates tight risk management, precise entry/exit points and emotional discipline. It’s often favoured by experienced scalpers or day traders who make many small, quick trades.
Conversely, low leverage trading reduces the risk of rapid account depletion. While the potential for amplified returns is also lower, adverse price moves tend to be less devastating.
Choosing the right leverage level for your trading style is paramount. For beginners, starting with low leverage can be useful while you build familiarity with the markets and confidence in trading. As your experience grows and risk management skills are honed, leverage can be gradually increased.
Low leverage is also preferred for long-term trades (like position trading). Long trades are inherently exposed to more market volatility over time. Low leverage provides the necessary breathing room to ride out short-term fluctuations and reach your long-term targets without the constant threat of margin calls.
Ultimately, the ‘right’ leverage is the one that aligns with your risk appetite, trading strategy and ability to manage the associated psychological pressures.
Excited to apply the right trading strategies? Open a Live Account and get started.
Where can you use leverage?
Leverage is a versatile tool available across a broad spectrum of assets.
Forex
Leverage in forex trading tends to range, and may be higher in certain jurisdictions. This high leverage is possible due to the sheer liquidity and relatively lower volatility of major currency pairs compared to other assets.
Cryptocurrency
Since cryptos are traded in the same way as forex pairs, they are a natural extension of leverage in forex trading. Leverage ratios tend to be lower than for forex. The inherent high volatility of cryptocurrencies means even modest leverage can substantially magnify gains or losses.
Stock CFDs
Leverage on stock CFDs typically ranges depending on the regulatory jurisdiction. This enables traders to take positions in individual stocks or indices with a fraction of the capital required to buy physical shares.
Futures contracts
These are standardised agreements to buy or sell an asset at a predetermined price on a future date. The futures markets are inherently leveraged, as traders only need to deposit a fraction of the contract’s total value (known as initial margin) to control a much larger position. Leverage ratios in futures vary widely depending on the asset (commodities, indices, currencies) and the exchange.
Regulatory aspects of leverage
The regulatory landscape for leverage trading is complex and varies significantly across jurisdictions. Regulators worldwide aim to protect retail traders from the amplified risks associated with leverage by restricting the amount of leverage offered.
A key distinction made by regulators is between retail and professional traders. Retail traders are typically individual market participants with less experience and capital than professional traders. Professional traders, on the other hand, are usually institutions or high-net-worth individuals who meet specific criteria regarding trading experience, financial knowledge and capital. Regulators impose much stricter leverage limits and offer greater protections (like negative balance protection) for retail traders.
Major regulatory bodies across the world play a significant role in setting leverage limits by region. For instance, the European Securities and Markets Authority (ESMA) introduced strict leverage limits for retail traders in 2018.
Meanwhile, the US Commodity Futures Trading Commission (CFTC) limits leverage to 1:50 for major currency pairs and 1:20 for minor pairs while the Australian Securities and Investments Commission (ASIC) enforces similar limits to the ESMA.
Tools and platforms for leverage trading
Choosing the right platform is as crucial as developing effective leverage trading strategies.
One of the most widely used platforms in retail trading is MetaTrader. Available in two main versions, MetaTrader 4 (MT4) and MetaTrader 5 (MT5), it offers robust charting tools, a wide range of technical indicators and the ability to automate trading using Expert Advisors (EAs). Its popularity stems from its user-friendly interface, extensive customisation options and broad support from brokers worldwide.
Thinkorswim is another highly sophisticated platform, popular among US-based traders, particularly for options, futures and stock trading with margin. It provides advanced charting capabilities and analytical tools, paper trading, and rich educational resources. It caters more to experienced traders.
The TradingView platform offers a unique hybrid solution. It is primarily known for its exceptional charting capabilities, social trading and extensive trader community. Users can connect their TradingView accounts to supported brokers to execute trades directly from TradingView charts.
What to look for in a leverage trading platform
- Reliability and execution speed
- Charting and analytical tools
- Intuitive user interface
- Robust security
- Responsive customer support
- Supported instruments
- Competitive fees and spreads
- Risk management features
Real-world examples of leveraged trades
Here are some real-world examples to illustrate the mechanics of leverage trading.
Example of forex trading with 30:1 leverage
Scenario: you expect EUR/USD to rise.
Account capital: $5,000
Leverage used: 30:1
Trade size: you decide to open a standard lot position (100,000 units).
Initial margin required: $100,000 / 30 = $3,333.33
Entry price: 1.0800
Target price: 1.0900 (100 pips profit)
Stop-loss: 1.0750 (50 pips loss)
Outcome 1: price rises to 1.0900 (profit)
Profit = 100 pips x $10 per pip = $1,000
Return on initial margin = ($1,000 / $3,333.33) x 100% ≈ 30%
Return on account capital = ($1,000 / $5,000) x 100% = 20%
Without leverage, to make $1,000, you would need to invest $100,000 of your own capital.
Outcome 2: price falls to 1.0750 (loss - stop-loss hit)
Loss = 50 pips x $10 per pip = $500
Loss on initial margin = ($500 / $3,333.33) x 100% ≈ 15%
Loss on account capital = ($500 / $5,000) x 100% = 10%
This demonstrates the amplified impact of leverage, where a 0.46% (50 pips / 1.0800) move against your $100,000 position results in a 10% loss on your $5,000 account.
Example of crypto trading with margin
Scenario: you expect Bitcoin (BTC) to fall.
Account capital: $10,000
Leverage used: 2:1
Trade size: you decide to short BTC worth $20,000.
Initial margin required: $20,000 / 2 = $10,000
Entry price: $60,000 per BTC
Target price: $58,000 per BTC ($2,000 profit per BTC)
Stop-loss: $61,000 per BTC ($1,000 loss per BTC)
Outcome 1: price falls to $58,000 (Profit)
You shorted approximately 0.33 BTC ($20,000 / $60,000).
Profit = 0.33 BTC x $2,000 per BTC = $660
Return on initial margin = ($660 / $10,000) x 100% = 6.6%
Outcome 2: price rises to $61,000 (loss - stop-loss hit)
Loss = 0.33 BTC x $1,000 per BTC = $330
Loss on initial margin = ($330 / $10,000) x 100% = 3.3%
This example highlights that even with a low leverage of 2:1, the percentage profit or loss on your initial margin can still be significant.
Using a profit/loss calculator
Many trading platforms allow you to calculate leverage with a profit/loss calculator. For this, you need to input your capital, leverage, entry/exit prices and position size to see the potential profit or loss in monetary terms and as a percentage of your capital. Such tools can help you understand the implications of leverage before risking real money.
Best practices for leverage trading
Leverage trading requires discipline, continuous learning and following the best practices to navigate risks effectively. Without these, even the most promising leverage trading strategies can lead to significant losses.
The best practice is to start with a demo account. A demo account allows you to trade with virtual money in a simulated real-life market environment. This provides an invaluable opportunity to understand how leverage works in practice, test various leverage trading strategies and get comfortable with your chosen trading platform without any financial risk.
Next, it is vital to track your leverage use and exposure meticulously. Don’t just focus on your account balance; be aware of the total notional value of your open positions. Many traders fall into the trap of over-leveraging, with multiple small positions collectively amounting to a massive exposure. Regularly calculate your effective leverage to ensure it aligns with your risk tolerance.
Keep a trading journal for all your leveraged trades. Document your entry and exit points, reasons for opening the trade, leverage used, stop-loss and take-profit levels, and the emotional state during the trade. Reviewing your journal can help identify patterns in your trading behaviour, understand what strategies work (or don’t work) with leverage, and pinpoint areas for improvement in your decision-making and risk management.
Most importantly, learn to manage emotions in leveraged positions. The amplified profits and losses in leverage trading can evoke strong emotions like greed, fear and frustration, which can lead to impulsive decision making. Keep emotions at bay by sticking to your trading plan. Also, take breaks, don’t check your trades constantly and accept losses as learning opportunities.
Understanding the psychological pressure of risks of leverage trading is as important as understanding the technical aspects.
Summary and key takeaways
Leverage trading is a powerful financial tool that allows traders to control larger positions in the market than their account capital would permit. However, it is a double-edged sword because it amplifies both profits and losses.
Final checklist: ‘Should I use leverage?’
- Do I fully understand what is leverage in trading and how does leverage work?
- Have I practised extensively on a demo account?
- Do I have a robust risk management plan, including stop-losses and position sizing?
- Am I aware of the risks of leverage trading, especially amplified losses and liquidation?
- Can I manage the psychological pressure associated with leveraged positions?
- Am I using a reputable broker with appropriate regulatory oversight?
- Is the leverage level I’m using appropriate for my experience and risk tolerance?
Quick dos and don’ts
Dos:
- Start small and gradually increase leverage as you gain experience.
- Use stop-loss orders on every trade.
- Understand your margin requirements.
- Keep a detailed trading journal.
- Choose a regulated broker with negative balance protection.
- Keep emotions out of trading decisions and stick to your trading plan.
Don’ts:
- Don’t use the maximum leverage offered just because it’s available.
- Don’t overtrade or take on excessive positions.
- Don’t chase losses by increasing leverage.
- Don’t ignore margin calls.
- Don’t trade with money you cannot afford to lose.
- Don’t rely solely on leverage without a sound trading and risk management strategy.
Leverage may be a very powerful tool, but it needs to be used wisely and with caution. It can unlock more attractive opportunities in the financial markets for those who understand the concept well and use proper safeguards. However, it can also magnify losses just as quickly.
Visit our other complete guides
The ultimate guide to margin trading
A guide to trading vs investing
