Leverage explained: What is leverage in trading?
Leverage is one of the most important concepts to understand when trading in the financial markets like forex, share CFDs, crypto CFDs and indices.
It’s the reason traders are able to gain full exposure to a trade and potentially see larger returns or bigger losses, despite not having the full amount of equity - something you’d need when trading traditional stocks or bonds.
Put another way, leverage makes trading more accessible by letting a trader trade more than they physically have. This happens in much the same way as someone purchasing a house by borrowing from the bank; if you can deposit a percentage of the total value, the bank will cover the difference. When applied to trading, it has you putting up a portion of the full trade amount with your broker covering the rest.
Before we deep dive in, let's understand a fundamental definition of the concept of 'leverage' in trading.
What is leverage in trading?
Leverage is a ratio representing the level of exposure you have to a trade. Using leverage means you can control trades of higher value than the margin you hold.
How does leverage work?
Suppose a trader has $1,000 in their account but feels that’s not enough to trade with. They might then opt to use the leverage provided by a broker. If they chose to use 10:1 leverage, their investment potential would turn into $10,000 (1,000 X 10). The broker will take a certain amount as margin - which varies between the different financial instruments - and essentially lend you the rest to enable you to open the position.
The benefit of leverage is that it gives traders the ability to enter and control larger funds using a small margin. This is appealing to many traders, but it is important to remember that margin trading and leverage can be a double-edged sword as they can magnify both wins and losses.
Brokers will let you adjust your leverage up or down to suit your needs, as far as 400:1 in some cases which offers some big returns from a small outlay. That can be great in theory - especially so when it comes off - but there’s another side to leverage traders must always remember: leverage not only amplifies your profits, but your losses too. So the higher the leverage, the greater the risk.
To show the relative negative impact of leverage, let’s consider a scenario whereby two traders decide to put their $10,000 of capital behind the same trade but using different leverage sizes. Unfortunately for them, the trade goes against them to the tune of 100 pips.
As you can see, the results for each trader are significantly different, with the higher ratio of leverage greatly amplifying the loss of Trader X - in one trade, they have wiped out half of their equity. While Trader Y still experienced a loss, the more conservative approach to leverage means that, as a percentage, there was a lesser effect on their total equity.
The obvious conclusion from the above example is that if you want to mitigate risk it’s sensible to use less leverage.
What is a leverage ratio?
Leverage ratio measures your total exposure compared to your margin. For example, if you open a trade worth $10,000 with $1,000 in available funds, you are utilising the leverage of 10:1.
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