What is financial leverage?
Financial leverage is the use of borrowed capital to make investments. As a result, financial leverage has the potential to increase returns or profit from the project. At the same time, using financial leverage also increases the risks the user has to bear if the investment isn’t successful.
In this article you’ll learn what is leveraged trading, how it works, what kinds of leveraged trading there are, how to apply leverage in trading, what advantages and disadvantages leverage has and how to mitigate potential risks.
What is leveraged trading?
Leverage is a very widespread trading strategy that involves traders borrowing money from brokers in order to open positions larger than they can afford with their own funds. Leveraged trading is especially popular in forex as you can get much higher leverage for forex trading than for any other assets.
How does leveraged trading work?
To understand how leveraged trading works, you need to understand what leverage actually is. Leverage is the ratio between the amount of money you deposit to your trading account and the amount of money you can trade with. What you deposit is just a smaller part of the funds you can spend on trading. The rest are provided by your broker. This ratio is usually expressed as X:1, where X is how much more money you can access after depositing your personal funds. For example, when you use leverage of 100:1 and deposit $100, you can trade $10,000 worth of assets.
Trading on margin
Trading on margin is one of the most common examples of leveraged trading. Margin is the amount of money that you need to put forward to open a trade. Trading on margin allows you to trade more assets than you can afford with your cash alone.
Note that when it comes to forex, margin trading requires you to make the initial payment to the broker in order to get leverage to buy assets. To trade on margin, you need to open a margin account where you deposit money to, and this money is used as the collateral. Margin trading increases both your potential gains and potential losses, and it also gives your broker the right to close your positions without your consent if you don’t have enough money on your margin account.
Trading on derivatives
Leverage can also be applied to derivatives trading. Derivatives are financial instruments the value of which is derived from an underlying asset. Derivatives allow traders to acquire the right to buy or sell assets at a specific price, and thus have greater flexibility in trading.
Leveraged exchange-traded funds, or ETFs, are trading instruments that greatly amplify the profit from investments through the use of use a combination of derivatives and debt instruments. But traders should be careful while trading leveraged EFTs as it can be quite risky. ETFs track a basket of stocks in one sector and help to diversify their holder’s portfolio. Traditional ETFs’ price moves together with the price of stocks they track on one-to-one basis. However, leveraged ETFs aim for 2:1 or 3:1 ratio and thus may bring in more profit.
Leveraged ratios in financial markets
You can use leverage to trade in different markets, but the amount of leverage you can use varies greatly and depends on the type of assets you plan to trade.
Leveraged currency trading
Forex market is the largest financial market in the world. Forex traders can use a relatively high leverage, going up to 1000:1 for professional traders. This makes forex trading more profitable, but also riskier.
Leverage for indices
Indices reflect the general performance of a group of assets related to a particular industry or sector. Leverage for this market is quite low, the highest possible ratio being 200:1.
Leveraged stock trading
Stock trading is another area where traders can use leverage. Compared to other markets, stock market offers rather low leverage ratios. At FBS, the maximum leverage ratio you can get to trade stocks is 100:1.
Leveraged cryptocurrency trading
Cryptocurrencies are very volatile assets, so leverage ratios for them are very low, starting from 5:1. This is a cautionary measure because using high leverage for crypto trading can result in huge losses.
Risks of excessive real leverage in forex trading
Using too big of a leverage in forex trading may bring huge profit, but also big losses. The greater the leverage you use, the more risk you might have to bear.
Margin risks and margin call
If your margin level depletes and falls below a set amount, your broker may start a margin call. This means that you have to deposit more money into your account to prevent your broker from closing your positions to get its money back.
Potential for unlimited loss with options
Options require their sellers to buy or sell assets at the price specified in these options. So if the buyer executes it, the seller is already taking a loss, the size of which depends on how much the asset price has gone up or down. There’s no limit to how much the price can change, which means there’s also no limit to how much profit you can lose.
Not suited for long-term trading
Leveraged ETFs are generally used for intraday trading because they may gap at the opening of the next day. Using them for anything other than short-term trading means that the profit you receive can be really far from your goal.
How do you calculate leverage ratios?
In order to calculate leverage ratio, you need to divide the asset amount by the margin amount (equity). For example, if you want to buy $500 worth of forex and you have $100 on your margin account, you’ll need a leverage ratio of 5:1.
How does forex margin compare to stock trading?
Trading forex gives you significantly more leverage (100:1 or more for professional traders). Though this might seem risky, forex pairs don’t change prices that much, especially within one day, so the risk is also much less than it could be in other trading markets.
Are forex markets volatile?
Forex markets are generally considered one of the most liquid markets, which means they are less volatile. However, currency rates depend on a multitude of constantly changing factors, like global and local economy, geopolitics, commerce etc. So traders have to be aware that these events can cause significant volatility in currency pairs.
How much leverage should I use?
Leverage might seem an easy way to make a lot of money quickly, but it’s also one of the main reasons traders lose so much money. If you decide to use leverage, don’t start with the 100:1 rate, especially if you’re a beginner and still learning the ropes. It’s better to use smaller leverage (10:1) and steadily build up your capital and gain experience than lose all your money within one day.
Leveraged trading: pros and cons
There are many advantages to trading on leverage that attract traders:
- high profits – leverage multiplies the amount of money you have, making your potential profits much higher;
- access to higher-value stocks – with leverage, you can buy assets that you never would afford with your own money;
- much larger positions – leverage allows you to enter into more trades at the same time and buy more assets without using your entire capital.
However, there are certain disadvantages that traders should think about before deciding to use leverage:
- losing the ownership of the assets – if your trades are losing, your broker can close your positions without your consent, and then you’re left without both the asset and the money;
- more risk – leverage does increase your gains, but it also increases the amount of your potential losses if the market goes against you.
Example of leverage in stock trading
Let’s say you decided to buy $10,000 worth of stocks and used your own money to do this. This is 1:1 leverage (in essence, this is an unleveraged position), as you don’t borrow anything from the broker. If you earn $100, your return will be 1% ($100/$10,000*100). At the same time, if you lose $100, your loss will be just -1% return as well.
Imagine that you don’t have $10,000, but want to trade this amount. This is when leverage comes into play. In this case, your broker will require, say, 1% margin equal to $100 on your account. This is your used margin. The leverage is 100:1 because you control $10,000 with just $100. The remaining 99% is provided by the broker. The margin is needed for broker’s security in case the market goes against your position. In the case of $100 profit, your return will be 100% ($100/$100*100). However, if you lose $100, the return will be -100%. As you can see, with leverage stock trading can result in larger profits or larger losses when compared to an unleveraged position.
Retail leverage vs professional leverage
Leverage rates depend not only on the market you’re trading in, but also on the type of trader you are. Generally, leverage rates for retail traders are lower than for professional traders, but it also limits the amount of losses they risk to bear. Besides, there are more criteria that professional traders are required to meet in order to be eligible for leverage.
Leverage risk management
Since with high leverage comes great risk, it’s extremely important to have a good risk management strategy before implementing leverage into one’s trading. Apart from avoiding using too much leveraged capital in trading, traders can also utilize Stop Loss orders for their positions. Stop Loss orders make your positions automatically close once a certain threshold is crossed, minimizing the amount of loss you can bear. It's also better to use leverage in short-term trading.
The bottom line
Leverage allows traders to open larger positions than they would have done with their own money. The amount of leverage traders can get depends on the volatility of the asset and whether they are professional traders.
Besides increasing potential returns, leverage also amplifies potential risks. There are multiple ways to mitigate the risks and manage potential losses, but the main thing traders should remember is to never use leverage thoughtlessly.
Is leveraged trading dangerous?
Leveraged trading is riskier than trading without leverage as traders can lose not only their own money, but also the money they don’t own. In some cases, traders can even lose the asset they bought with leverage.
Do you have to pay back the leverage?
Yes. You essentially borrow money from your broker, so you naturally have to return it. Some brokers also charge interest on trading with margin, so leveraged trading also increases your expenses.
How does leveraged trading work?
When traders use leverage, they borrow money from their broker to spend it on buying assets. This allows traders to open more positions and buy more expensive assets than they can afford with their money alone.
2022-09-22 • Updated