What is Leverage Trading? Your guide to growing a position with borrowed funds
Leverage trading is used to achieve higher investment returns. However, leverage can also magnify losses.
There are various leverage trading instruments available to choose from, based on your preferred trading strategy and goals.
Risk-management tools, like stop-loss orders, give traders the opportunity to shield themselves from potential losses.
What does leverage mean in trading? Here, we take a look at the risks and benefits of leverage trading, risk management strategies and more. You will also learn about options, leveraged exchange-traded funds (ETF) and contracts for difference (CFD).
What is leverage trading?
In the world of finance, leverage is the use of debt in investing. Leverage can magnify gains and losses.
Leverage trading is buying and selling of assets with borrowed capital or debt.
Trading with leverage is facilitated by the use of leveraged investment strategies. The three most common are trading margin, options and leveraged exchange-traded funds (ETF).
What is your sentiment on US100?
How does leverage trading work?
Let’s discuss those three strategies with leverage trading examples. This should help you understand how leverage works in trading.
Margin trading
Margin trading occurs in ‘margin accounts’, a type of a brokerage account where the broker lends you money known as a ‘margin loan’ to buy securities. Margin trading can also be used for short selling.
In margin trading, your brokerage account is considered collateral for the margin loan. For example, let’s say you purchase a stock worth $150 by paying $50 of your own money and $100 in a margin loan.
If the stock rises from $150 to $200, you will have made a 100% return on your $50 investment since the $50 gain is 100% of investment made using your own money. But, you will have to pay the broker the borrowed $100 and interest on it.
However, if the stock falls from $150 to $100, you would have incurred a loss of about 33% had the entire amount been paid from your pocket. Since the investment of $150 was made using a $100 loan, you will incur a 100% loss to your initial $50 investment. Furthermore, you will have to pay back the broker the $100 debt plus interest.
Options trading
Option trading is the buying and selling of financial instruments called options. Options are derivative contracts that give the holder the right to buy or sell an underlying asset at a predefined price on or before a specific date. The underlying asset can be stocks, indices, fixed-income assets, foreign exchange, commodities and ETFs.
An option contract usually represents the right to buy or sell 100 units of an underlying asset. Margins can be used to trade option contracts.
There are two types of option contracts. A call option allows the contract holder to buy the underlying asset at a stated price within the predefined time frame. A put option gives the contract holder the right to sell the underlying at a stated price within the predefined time frame.
A call option has a bullish buyer and a bearish seller, whereas a put option has a bearish buyer and a bullish seller.
Let’s take a look at an example. A trader is bullish about stock X that is currently trading at $48. Instead of buying 100 shares of X, the trader purchases an X September 50 call contract with a strike price of $50. The premium of the contract will be about $2 and the total price of the contract will be $200 ($2 x 100).
Let’s say the expiration date for the contract is the last Friday of the month. For the option contract to be ‘in-the-money’, X has to trade above the strike price of $50. Furthermore, since a premium paid per share is $2, X would have to trade at $52 for the trade to break even.
If X rises to $60 before expiration, the premium on the X September 50 call contract will rise to about $10. The contract will now be worth $1,000 ($10 x 100). If a trader sells the contract with X trading at $60, they will book a profit equal to the difference between the contract's buying and selling price, which in this case is $800.
However, if the market goes against the trader and X drops below the strike price of $50 on the expiration date, the option contract will be deemed ‘out-of-the-money’ and will expire worthless. This will result in the trader losing all their initial investment.
Leveraged ETFs
Leveraged ETFs track the performance of market indices linked to equities, commodities, foreign exchange or other benchmarks with the aim to deliver multiples of performance.
For example, a 2x leveraged US Tech 100 ETF will seek to deliver twice the investment return of the US Tech 100 index (US Tech 100). However, this can also result in the doubling of losses.
According to the US SEC’s investor bulletin published in June 2021, leveraged ETFs utilise a range of investment strategies via futures contracts, swaps and other derivative instruments.
It should be noted that leveraged ETFs are typically designed for managing daily trading risks and are not suitable for a ‘buy and hold’ strategy.
Contracts for difference (CFD)
A CFD is a contract between a broker and a trader to exchange the difference in value of an underlying security between the beginning and the end of the contract.
A CFD is a leveraged financial product. Traders with CFDs or margin accounts need to put down only a fraction of the total capital required to open a leveraged trading position. The rest of the capital is lent to traders by their brokerage company.
The initial amount required to open a CFD position is known as margin deposit, which is a percentage of the trade’s total value. A trader will also need a minimum amount of capital in their account, known as a maintenance margin, to keep a leveraged trade open.
Traders may be asked to deposit additional capital in their account to keep positions open, in case their trades start to make a loss. This is known as a margin call.
What is the leverage ratio?
Leverage ratio is the measure of a trader’s total market exposure to their margin requirement. It shows how much of a trade is magnified by margin from the broker.
For example, let’s say a trader wants to open a US dollar index (DXY) position worth $1,000 in the market. The brokerage provides a 10% margin, which allows the trader to open the position with a deposit of $100. The leverage ratio is 10:1.
Brokerages may choose to provide varying leverage limits for different asset classes, ranging from equities, major currencies, non-major currencies and commodities.
Risk of leverage trading
Trading with leverage comes with risk. Here are important points to know about the risk of leverage trading, according to the US SEC’s investor bulletin:
Margin traders may be required to deposit additional cash or securities in their account to cover market loss. This event is called a margin call.
Margin traders may also be forced to sell some or all of their securities when falling markets reduce the value of their securities.
Margin trading can lead to traders losing more money than invested.
Brokerages may choose to increase margin requirements and may sell some or all of a trader’s securities to cover margin loans.
Margin traders may not be entitled to extension of time in the event of a margin call.
Option trading can result in traders losing their entire initial investment and more.
Option writers selling option contracts can expose themselves to unlimited potential losses.
The performance of leveraged ETFs may differ significantly from the performance of the underlying benchmark index.
Leveraged ETFs use complex investment strategies that can expose holders to risks associated with these investment instruments.
Risk management for leverage trading explained
There are risk management tools and strategies available for traders to protect themselves against losses while using leverage.
Stop-losses
Stop losses are designed to buy or sell a specific asset when its price reaches a certain level. There is a difference between stop-losses and guaranteed stop losses. A stop-loss may fail to exit the trade at a specified price level, such as in times of extreme volatility. A guaranteed stop loss provides more protection and, typically, comes at an extra cost.
Traders can limit their risks on both long and short trades by using stop-losses. Furthermore, stop-loss orders can help traders make decisions free of emotional influence, thereby allowing execution of planned trades in line with the trading plan in place.
Sell stop-loss orders automatically exit positions when the price of the asset falls below a predefined price. A buy stop-loss order is triggered automatically when the asset price rises to a specified level.
Negative balance protection
Brokerages often offer negative balance protection to clients, which ensures that traders do not lose more money than they have in their trading accounts, according to the European Securities and Markets Authority (ESMA), which says:
Risk-reward ratio
The risk-reward ratio is a useful risk management tool. The ratio represents the prospect of a reward for every $1 an investor is willing to risk.
Risk-reward ratios are generally used to compare expected returns on various investments. For example, a trading position with a risk-reward ratio of 1:5 indicates that an investor can earn $5 at the risk of losing $1. A trading position with a risk-reward ratio of 1:2 indicates a return of $2 if the investor is willing to risk $1.
Investors can manage their stop-loss and take-profit orders according to their preferred risk-reward ratio and can plan their stop-loss orders accordingly.
Final thoughts
The use of leverage in trading can be a double-edged sword. Leverage can increase potential returns from a pool of capital but can also result in higher losses.
It is critical for traders to understand the various risks associated with different types of leverage trading instruments. Traders also need to be aware of tools and strategies that can help them make the optimum use of leverage when trading.
Always conduct your own due diligence and do your own research before trading. Remember that your decision to trade or invest should depend on your risk tolerance, expertise in the market, portfolio size and goals. Never trade money that you cannot afford to lose.
FAQs
Is leverage trading worth it?
The use of leverage in trading can be a double-edged sword. Leverage can increase both profit and loss.
Are leverage and margin the same?
How to calculate leverage in trading?
Leverage is equal to the amount of money borrowed to trade.
What is a good leverage ratio?
Leverage ratio is the measure of a trader’s total market exposure to their margin requirement. It shows how much of a trade is magnified by margin from the broker. An appropriate leverage ratio would depend on your risk tolerance, trading strategy and account size. You should do your own research to find out what is an appropriate leverage ratio for you.
Markets in this article
Related topics
