What is leverage?

Trading with leverage enables you to open and maintain a much larger position than you could with the funds in your trading account alone. This allows you to increase your market exposure. But remember that while increasing market exposure means your potential profits are multiplied, it also means potential losses will also be magnified. That’s why it’s so important to have a good understanding of the meaning of leverage and how it works before applying it to your trading strategy.

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.

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.

On the other hand, leverage also multiplies potential losses in the same way it magnifies profits. A small negative price movement could wipe out your entire initial margin. If the market moves against you, your broker may issue a margin call, requiring you to deposit more funds to keep your position open. If you can’t, the position may be automatically closed at a loss.

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 is leverage in trading?

Leverage is a financial tool that allows you to control a larger trading position with only a small amount of your own capital. The remaining amount is funded by the broker. This means you can open a much larger position than what you could with your funds alone.

What is leverage and margin trading?

Leverage is the ratio that determines how much you can borrow from your broker. Margin trading is the practice of using this leverage. Margin is the collateral, or the small amount of your own capital, required to open a leveraged position.

What is leverage in day trading?

In day trading, leverage is used to capture profit from small, intraday price fluctuations. Since your position size is magnified, small price moves bring higher profits. However, day traders must use effective risk management measures since losses will also be multiplied.

What is leverage in futures?

Leverage in futures trading works in the same way to increase your market exposure. A futures contract has a large notional value. The margin required to trade that contract is only a fraction of its total value.