What is financial leverage?
How does leverage work?
Leverage works by your broker effectively lending you money to open a larger trade. The amount of your own capital required is called the margin. The leverage ratio determines how much you can borrow. For instance, with a leverage of 50:1, you can open a $5,000 position with just $100 of your own money. The broker provides the remaining $4,900. When you close the trade, the broker takes back its loaned capital, and you either keep the profit or absorb the loss.
Key takeaways
Leverage enables traders to control larger positions than their account balance by borrowing from brokers, where the trader's capital (margin) serves as collateral; for example, 50:1 leverage allows controlling a $5,000 position with only $100.
The leverage ratio (written as 10:1, 50:1, or up to 500:1 in forex) determines how much you can borrow, with higher ratios meaning less personal capital required but also significantly greater risk exposure.
Leverage increases purchasing power and lowers entry barriers while freeing up capital for other investments, as even small price movements can generate higher gains compared to trading with your own capital alone.
Leverage equally magnifies losses as it does profits, making it a double-edged sword where small adverse price movements can wipe out entire margins and trigger margin calls requiring additional deposits or automatic position closure.
Leverage is available for CFD trading across almost all asset classes including forex (up to 500:1), futures, and day trading, but risk management and demo account practice are crucial before live trading.
It’s a simple concept, but it has major implications. A small move in the market against your position can quickly deplete your initial margin. This makes risk management crucial while trading with leverage.
Leverage example
Let’s try to understand how leverage works with a simple example.
Imagine you want to buy 100 shares of a company where each share costs $50. The total value of your position is $5,000.
Your broker offers a 10:1 leverage. This means you only need to put up 1/10 of the total value. This amount is your margin. In this example, your margin would be $5,000/10 or $500.
The broker loans you the remaining $4,500.
Now, let’s say the share price goes up to $55. The total value of your position is now $5,500. So, you decide to sell the shares and get back your initial $500 margin plus the $500 profit. Your total profit is $500 on a $500 investment, which is a 100% return.
Without leverage, you would have bought only 10 shares with your $500. The profit would be $50 (10 shares * $5 profit/share).
But what if the price goes down? If the share price drops to $45, your position is now worth $4,500, and you've lost $500, which is your entire initial margin. This is why leverage is often called a double-edged sword.
Before you use leverage in the live markets, practice on a demo account without risking real money. Open a demo account to learn how trading with leverage works.
What is the difference between leverage and margin trading?
The terms leverage and margin trading are often used interchangeably. But they refer to different aspects of the same concept.
Leverage is the ratio of the total trade size to your required margin. It’s the multiplier that increases your position size.
Margin trading, on the other hand, is the act of using borrowed funds from a broker to trade. The margin itself is the collateral you put down to open a leveraged position. So, while leverage is the tool, margin is the capital required to use that tool.
Learn more about what leverage is in our day trading piece.
What is leverage ratio?
The leverage ratio expresses the relationship between the total size of your position and the margin you must deposit. It is written as a ratio, such as 10:1, 50:1, or 500:1. A higher ratio means you can control a larger position with a smaller amount of your own capital. For example, a 100:1 leverage ratio means you only need to put up 1% of the total position’s value as margin. This is common in forex and futures trading. However, as mentioned earlier, a higher leverage ratio also means greater risk. A small adverse price movement can lead to a quick margin call or the liquidation of your position.
What are the risks and benefits of leverage?
To make an informed decision about trading with leverage, you must know its pros and cons.
One of the main benefits is that leverage increases your purchasing power. This means you can control a much larger position than your account balance allows. Since trading with leverage increases your position size, even small price moves can lead to higher gains compared to using your own capital alone.
Trading with leverage lowers entry barriers because you don’t need a large amount of capital to get started. This frees up your funds for other investments.
The potential for large gains and losses can lead to emotional trading decisions, which often result in poor outcomes. Finally, be careful of overleveraging or using a leverage ratio that is higher than your risk tolerance.
Leverage is one of the advantages of trading forex or futures via CFDs. Learn more about CFD trading.
Markets to trade with leverage
You can trade CFDs with leverage for almost all asset classes. Forex trading is a prime example, where leverage ratios can be very high, sometimes up to 500:1 or more. This is because currency pairs often have very small price moves. Futures trading also relies heavily on leverage. A futures contract controls a large notional value, but the margin requirement is a fraction of that value. A CFD is a derivative instrument, similar to futures contracts. It allows you to speculate on price moves without owning the asset. Also, day trading almost always involves some type of leverage.
Ready to explore the markets by trading with leverage? Create a live account.
FAQs
What does leverage mean in finance?
Leverage in finance refers to the use of borrowed capital, or debt financing, to amplify potential returns on investments, allowing companies to expand their operations beyond their existing resources. Leverage can also amplify losses and comes with the risk of default.
How to find leverage ratio?
To find the leverage ratio, key financial ratios such as debt-to-equity, interest coverage, and debt-to-asset ratios can be calculated using a company's balance sheet and income statement data.
Why is financial leverage important?
Financial leverage is important because it enables firms to achieve higher returns, access potential tax benefits, and increase their capital for growth opportunities, while also emphasising the need for prudent risk management due to the associated risks of default and increased interest costs. In fact, the free cash flow theory in finance states that firms that use debt financing waste less resources and ensure more discipline with budgets.