Hazem AlhalabiBy Hazem Alhalabi
Tamta-Suladze.pngBy Tamta Suladze
5/5(1)

Leverage Trading: What is it, and How Does it Work?

11
Leverage trading

Investing in financial markets is usually straightforward; you buy assets with your money and realise losses or gains resulting from market movements. In this context, you trade with what you can afford.

However, leverage allows you to trade with what you cannot afford. This tactic requires significant expertise and capital because the associated dangers can be massive.

In a nutshell, leverage trading enables you to place high-value orders by borrowing funds from the broker to seek high returns at higher risks. The drawback? Losing your money and owing the broker their capital.

Let’s explain how you can trade with leverage and what you need to consider before doing so.

Key Takeaways

  1. Leverage in trading allows you to multiply your initial investment by borrowing funds from the broker.

  2. Leverage is expressed in ratios, like 1:10 or 1:100, where $1 from the trader is matched with $10 or $100 from the broker.

  3. Different jurisdictions impose different limitations and caps, such as 1:30 in the UK and 1:50 in the US for major FX pairs.

  4. High market exposure enables you to benefit from tiny market movements and explore expensive positions you would not otherwise afford.

Understanding Leverage Trading

Leverage is a financial boost offered by the brokerage firm or the trading platform to allow traders to pursue trading positions without having to pay the entire amount. In essence, the trader must afford a percentage as a down payment while the broker provides the remaining amount required for the market order.

It is a high-risk, high-reward strategy that exposes the investor to default risk if the market moves unexpectedly or the trader fails to add sufficient funds before depleting the position.

However, trading on leverage allows investors to explore lucrative opportunities they would not otherwise afford, such as buying one Bitcoin ($100,000) or investing in stocks like Berkshire Hathaway Class-A ($682,500).

Leverage

How Leverage Works?

Trading with leverage allows you to control a larger position with a smaller initial investment, enhancing the potential for both profits and losses. It is typically represented as a ratio of the order’s amount, such as 1:10, which means the trader can trade while multiplying their capital ten times using the borrowed funds.

Traders must provide collateral for a portion of the position’s value, which the broker multiplies according to the leverage ratio, 1:10, 1:100 or even 1:1000. As the price of the asset fluctuates, gains or losses are calculated on the full order value, not just the trader’s initial investment.

While this tactic increases the potential for higher returns, it also magnifies risk, as small market movements can result in significant losses.

If losses exceed a trader’s equity, brokers may issue a margin call, requiring additional funds to maintain the position or forcing its closure to limit further losses. Therefore, investors must use advanced risk management strategies, such as stop-losses and limit orders, to protect capital.

Also, traders must be careful about the trading partner they choose. Unregulated operators may offer extremely high ratios, such as 1:500 or 1:1000, and put users at a significantly high exposure risk.

How leverage works

Trading with Leverage: Example

Let’s say you are offered a 1:10 leverage ratio. This means you can trigger a market order valued at $1,000 and pay only $100 from your equity while the broker finances the remaining $900.

You can use a leverage trading calculator to check how much you must pay or divide the position’s value ($1,000) by the second number in the ratio (10).

This can be particularly useful when executing a buy order for Bitcoin, but you cannot afford $100,000 upfront. For example, a 1:100 leverage ratio allows you to open the position with just $1,000 of your pocket.

Fast Fact

Warren Buffett famously criticised leverage, stating, “It’s only when the tide goes out that you discover who’s been swimming naked.” This highlighted its risk during market downturns.

How to Calculate Leverage Ratio?

To calculate the leverage ratio, divide the total value of the position by the amount of equity (capital) the trader contributes. The formula is:

Leverage Ratio

For example, if a trader controls a position worth $10,000 with $1,000 of their funds, the ratio is 1:10. This means the trader uses 10 times their initial investment to gain market exposure.

Understanding this calculation helps traders assess their risk, as higher leverage increases both potential profits and losses. Many brokers also provide calculators for quick assessment.

Basic Elements

Dealing with a leveraged position can be challenging. There are many concepts and financial commitments that you must consider. On the broker’s side, they put themselves in a highly dangerous situation, so they implement strict rules to ensure financial stability.

Initial Margin

The minimum amount of capital that you must deposit to open a leveraged position is called the initial margin. It acts as collateral for the borrowed funds and is calculated as a percentage of the total trade value. Brokers require this upfront payment to mitigate the risk of potential losses.

Leverage Ratio

This indicates the multiple exposures a trader can achieve relative to the initial investment. For example, a 1:10 ratio means $1 of capital controls $10 of market value. It amplifies potential profits and losses, allowing traders to manage larger positions with smaller capital commitments.

Understanding leverage ratio

Margin Requirements

This defines the minimum margin level a trader must keep, expressed in a percentage of the total value, to maintain the position. Brokers set the margin requirements differently between asset classes, regulatory guidelines, and market conditions.

Margin requirement

What Assets Can You Trade with Leverage?

You can use the leverage in almost any asset class. However, its usage is more popular in some markets based on volatility, liquidity and accessibility.

Forex

Using leverage in the foreign exchange market is popular due to the low volatility of major Forex pairs compared to other asset classes. As such, you would need to open high-volume lots using the broker’s funds to realise significant returns.

A 1:50 ratio is commonly used to profit from small price movements. The high liquidity and 24/5 trading hours make it ideal for Forex trading.

CFDs

Contracts for differences are widespread trading instruments that allow traders to access various markets without owning the actual asset.

You can execute leverage CFD ordered to gain exposure to a range of assets, including stocks, indices, and commodities. Some CFDs are limited to 1:30 or 1:50 ratios, depending on local jurisdictions and between institutional or retail investors.

Derivatives

Derivative contracts, like futures and options, are leveraged instruments because they allow you to hold market positions without paying the underlying asset’s price. Instead, you only pay the premium.

These financial instruments are widely used in markets such as commodities, stock indices, and bonds, serving both hedging and speculative purposes.

Futures contracts are favoured by institutional traders to gain substantial market exposure with relatively low capital requirements. At the same time, options provide more flexibility by enabling traders to limit potential losses while maintaining the opportunity for significant gains.

Cryptocurrencies

Cryptocurrencies are widely popular instruments to combine with leverage, especially with high coin prices and volatile markets. You can use crypto derivatives, such as futures and perpetual swaps, to hold a market position without paying the entire coin’s price.

Platforms often offer extreme leverage ratios (up to 1:100), allowing you to maximise returns in this highly volatile market.

Commodities

You can also use leverage in commodities like oil, gold, and consumer products through futures contracts. The large contract sizes and price volatility in commodities make leverage a practical choice for traders seeking higher returns.

Advantages and Disadvantages

With little investment, you can gain from lucrative market opportunities, especially during trend breakouts and price momentum. However, this increased exposure is the main leverage risk in trading.

Pros

  • Executing high-volume orders at a fraction of the price.

  • Earning significantly from small market movements.

  • Portfolio diversification between large and small positions.

  • Amplifying the impact of markets with low volatility.

  • Optimising gains from short-term trading strategies.

Cons

  • Increased exposure to high market risks.

  • Minor price pullbacks and corrections have a higher impact.

  • Having to add more funds to keep the margin account running.

  • Additional charges come from borrowing funds from the broker.

  • Your account may be liquidated forcibly if you fall below the margin requirement.

Margin vs Leverage

The two concepts are highly associated. Trading with margin factors in the leverage to amplify one’s buying power with the broker’s money.

Leverage entails borrowing capital from the broker to increase exposure to an asset or market. It is expressed in ratios like 1:10 and 1:100. A 1:10 ratio means the broker will multiply the investor’s investment by 10, or every $1 contribution by the trader will be matched by $10 from the broker.

This approach puts the trader at high risk if the market moves sideways or the gains do not offset the borrowing costs.

Margin is a mechanism that uses the operator’s funds while using the trader’s investment as collateral (margin). It facilitates leveraged trading by requiring an upfront payment equalling a fraction of the position’s cost (margin requirements).

It is expressed in a percentage of the order value, such as 10%, which means that every $1 invested by the trader will be multiplied by 10.

However, If the trader’s equity falls below the required margin level (here 10%) due to market volatility, the broker may issue a margin call, requiring the trader to deposit additional funds to restore the trading account balance or risk having the position liquidated.

Leverage Regulations

Due to the rising risks of margin trading, financial regulators in different regions and countries impose ratio caps and limitations to protect investors and ensure market stability.

Otherwise, brokers would offer uncapped market exposure, which, if widespread defaults occur, could threaten not only individual traders but also the broader financial system.

These regulations ensure brokers follow fair practices, such as negative balance protection, standardising margin requirements, and avoiding predatory high-leverage marketing. These measures aim to promote responsible trading and minimise systemic risk.

Traders can also use these tools to identify regulated platforms and ensure they only deal with operators that offer legally allowed limits.

UK Jurisdiction

In the United Kingdom, leverage usage is regulated by the Financial Conduct Authority (FCA), which focuses on protecting retail investors from excessive risks while maintaining fair and transparent markets.

Forex and CFD trading for retail clients are capped at a maximum leverage of 1:30 for major currency pairs and 1:20 for minors.

Higher limits are available to professional traders who meet specific eligibility criteria. However, the FCA bans crypto CFDs for retail traders due to their high risks.

The FCA implements strict rules for negative balance protection to ensure retail traders cannot lose more than their account balance.

European Regulations

In the European Union, leverage is governed by the European Securities and Markets Authority (ESMA), which prioritises transparency and limits risk for retail traders.

To protect retail investors, Forex and CFD leverage is capped at 1:30 for major pairs and 1:20 for minors. However, professional traders who meet eligibility criteria can access higher exposure.

ESMA mandates negative balance protection and standardised risk warnings across brokers. Individual member states may impose additional restrictions, especially on cryptocurrency derivatives.

However, futures trading remains regulated at the exchange level, with margin requirements varying by contract.

Leverage regulations in the EU

When to Use Leverage?

Only those with robust trading experience and significant capital are advised to use leverage due to the risks involved. Here’s where and when it is best to use it:

  • In low-volatility markets, such as Forex, leverage makes small price movements result in significant gains.

  • Trading highly liquid assets or short-term opportunities where quick returns are possible.

  • Significant cash reserves to cover potential losses without overexposing themselves financially.

  • Combined with other tools like stop-loss orders and position sizing to minimise risks while maximising potential benefits.

When Not to Use Leverage?

New traders or beginners are not recommended to engage in margin accounts because they can expose their accounts to a high liquidation risk if the market moves unexpectedly. Here’s when not to use it:

  • High market volatility, as small price movements, can lead to substantial losses.

  • Chasing losses or emotional trading without proper planning increases financial risks.

  • Illiquid assets or uncertain market conditions can also magnify losses.

  • Inability to monitor positions closely or have insufficient capital to meet margin calls.

Conclusion

Leverage trading is a highly popular way of capitalising on small price action and exploring high-value market orders. It is the amount of money the broker contributes to facilitate executing orders at high prices.

For example, a 1:100 ratio enables you to invest in a $100,000 position by paying $1,000 while the broker pays the remaining amount.

However, this amplified exposure comes with amplified risks. If the market moves unexpectedly, the broker will require you to add more funds, and if you fail to do so, your account might get liquidated.

FAQ

What is leverage in trading?

It is a multiplier that traders use to boost their market exposure using the broker’s funds. It is expressed in ratios and facilitates trading high-value orders while paying a fraction of the position’s cost.

What does 1:100 leverage mean?

A 1:100 ratio means that for every $1 of your capital, you can control a $100 position. This mechanism amplifies potential profits and losses, making it a high-risk option suitable for experienced traders.

What is the best leverage ratio for beginners?

Beginners can start with a low leverage ratio, such as 1:5 or 1:10. This provides enough exposure to learn market dynamics while keeping risks manageable, reducing the likelihood of significant losses.


What is a good leverage ratio for $100?

A good leverage ratio for $100 is 1:10, allowing you to control a $1,000 position while minimising risk. This small ratio can be highly effective in volatile markets such as cryptocurrencies and commodities.

Seeking answers or advice?

Share your queries in the form for personalized assistance.