What is leverage in trading — how does it work?

• Leverage allows traders to gain full market exposure through a small deposit called a margin. Potential profits and losses can both be magnified.
• Leverage usually comes in the form of a ratio, which determines how much a trader could borrow from their broker compared to the margin amount.
• Traders could trade using leverage in various markets, such as forex CFDs, index CFDs, or stock CFDs. 
• Leverage might allow traders to profit from small price movements in the market.
• Some risks might involve magnified losses, overnight fees for holding positions overnight, and margin calls.
• The leverage ratio that could be available to traders might depend on certain factors such as position size, the broker they use, and various financial markets they might want to trade.
• Another factor to consider when trading is the regulations of various regions that can influence the leverage ratio.

Leverage allows traders to open a bigger position with only a smaller amount of investment capital, called margin, in order to gain more exposure when trading the financial markets. 

Leverage might assist traders in growing their accounts through small price changes in the market. However, it's important to remember that leverage can either work with or against you.

If you decide to use leverage in trading, you need to deposit a small amount of capital called margin, as mentioned above, in order to open a position. The broker will borrow the remaining amount required to open the position, which you could use to increase your buying power in the market. 

When the position is closed, the amount borrowed will be returned to the broker, and you'll either receive the profits from the position or deal with the losses of that position.

Profits and losses are magnified with leverage trading because the trade results are based on the entire position amount, not just your deposit amount. That is why leverage is sometimes referred to as a double-edged sword.

The leverage that might be available to you will all depend on the broker you use and the regulatory authorities of your specific jurisdiction. Some traders could access more leverage than others, but more on that later.

You'll find that different types of traders use leverage in various ways. For example, experienced traders or those who are more risk-inclined will use higher leverage, whereas conservative and inexperienced traders will likely use lower leverage.

However, every trader should take into account the risks involved with leveraged trading. Trading with leverage could potentially wipe out your entire margin deposit fast if you're not cautious or don't have a good risk and money management plan.

As mentioned, trading with leverage works by depositing a small known margin to gain full market exposure.

Leverage usually comes in a ratio format. And to calculate the leverage ratio, you’ll need to divide the asset amount by the equity (margin) amount (L=A/E).

Let’s take the amount of $20,000 worth of AUD/USD, where you have to deposit $1,000 as margin. Using the calculation, you’ll take $20,000/$1,000 = 20, giving you a leverage ratio of 20:1.

On the other hand, if you want to calculate the margin amount you’ll need for the trade, you can divide the total value of the position by the leverage ratio, meaning $20,000/20 will give you $1,000. In other words, you’ll need $1,000 to open a $20,000 position at a leverage ratio of 20:1.

But, to better understand how leverage works when trading, let’s look at an example below.

For this example, we'll use the identical amounts and leverage ratio we calculated in the previous section. Let's say, a trader predicts AUD/USD will decline and opens a sell position of $20,000 with a margin amount of $1,000 at a leverage ratio of 20:1.

Now, let's assume the trader was correct in their prediction, and AUD/USD fell by 5%; they would've made a profit of $1,000. However, if they were incorrect in their prediction and AUD/USD appreciated by 5%, then the trader would've made a loss of $1,000.

Let's look at an example without leverage to show how it can impact a trader's capital. We can use the same amount of $1,000, which the trader has used as capital, but now their only exposure to the market is $1,000 and not $20, 000.

So, the trader predicts the market will decline, in which case they sell AUD/USD. The prediction was correct, and the market fell by 5%, but because they didn't use leverage, they only stood to profit $50. This is the same if the market went in the opposite direction by 5%; they would've only made a loss of $50.

As you can see, leverage can magnify both profits and losses, which is why trading with leverage has to be done with caution.

As previously mentioned, the margin is a deposit paid into your account to open a position. It can be seen as a security deposit, allowing you to open much bigger positions.

Most brokers will display the margin amount needed to open a specific position on their platform.

If your account experiences a certain amount of losses, the broker will send out a margin call notification. This notification means that the required margin amount has fallen below the required level to open a trade.

Once you receive a margin call, it's an indication to add more funds to your account to continue trading. However, if you don't, the broker can automatically close your open trades at the current market price to prevent the margin from falling to zero.

You could trade various markets using leverage, such as stock CFDs, forex CFDs, or index CFDs. Let's take a look at each of these in more detail below.

Leverage in stock CFDs

Stock CFDs are essentially a unit of ownership in publicly traded companies on the stock market. These companies can include blue-chip stocks such as Google and Microsoft, or lesser-known stocks called penny stocks.

Because leverage is used with derivative products such as CFDs, trading stock CFDs with leverage allows you to either go long (buy) or short (sell) in the market.

Leverage in forex CFDs

Not only is the forex market the most traded financial market around the world, but it's also one of the most popular markets to use leverage when trading.

For the most part, market movements with the majority of forex pairs are generally minimal. However, these small movements through leverage can have a significant impact on either your profits or losses.

Leverage in index CFDs

Index CFDs are classified as a group of stocks from various exchanges to track the overall performance of those stocks. Some of the most popular indices to trade include the Dow Jones 30, S&P 500, and ASX 200.

Since indices aren't physical assets, you can only trade them through derivative products such as CFDs. However, trading indices allows traders to trade a group of assets rather than individual assets.

Trading with leverage can be a powerful tool if used correctly and with caution. However, it also offers some benefits, so let's have a look at some of them.

• Leverage allows traders to trade more expensive instruments set at premium prices, which would otherwise have been difficult for many traders to participate in.
• Every trader has to deal with market volatility. Participating in a highly volatile market is ideal for most traders because of the constant price movements. In contrast, low-volatile markets have fewer constant price movements. That said, traders could gain returns in low-volatility markets even if the price movements are small.
• As mentioned, trading with leverage could offer traders the chance to gain bigger profits on their accounts if used wisely.
• Leverage could be seen as a 'loan' being provided by the broker. However, this type of 'loan' doesn't come with any interest fees, giving traders the ability to use it to its full potential, provided that they remain within their margin amount.
• If used wisely, leverage could give traders the opportunity to diversify their portfolio on various trades with only their margin deposit.

Even though leverage offers various benefits to traders, trading always involves risks. Let's look at some risks that might occur when using leverage.

• As mentioned above, one of the most significant risks involved in trading with leverage is the magnified losses to a trader's account because the results are based on the entire position amount and not just the margin.
• Another risk that traders must consider is a margin call. As mentioned above, when the trade starts going against you, there is a chance your losses could surpass the required margin amount to keep the position open. If this happens, your broker will send out a margin call notification stating that you could add more funds to your account or risk having all your positions closed automatically at the current market price.
• With leverage trading, you effectively borrow money from the broker to open a position. If you decide to hold on to your position overnight, you might have to pay an overnight fee.

Trading with leverage allows you to control a larger position size using a smaller initial investment capital, but it also increases your risk to market movements - both returns and losses. Effective risk management is essential to help reduce the impact of adverse price movements.

Common risk management tools

• Standard stop-loss orders: A standard stop-loss order automatically closes your position if the market moves against you and hits a predetermined level. While useful, stops aren’t guaranteed to execute at your exact price, especially during high volatility or gapping.
• Guaranteed stop-loss orders (GSLOs): Unlike standard stop-loss orders, a GSLO ensures your trade is closed exactly at the level you’ve set, regardless of market conditions. A small fee is typically charged if the guaranteed stop is triggered.
• Trailing stop order: A trailing stop order is placed at a predetermined distance from the opening price and automatically adjusts with the direction of your predicted position, whether that’s bullish or bearish. It will only stop adjusting once the market starts moving against you and automatically closes when triggered.
• Negative balance protection: This feature ensures your account balance won’t fall below zero, even during extreme market moves.
• Limit orders and price alerts: Limit orders could help you lock in profits, while price alerts notify you when markets hit specific levels - giving you time to act.

Building a risk management plan

A robust risk management strategy aims to limit potential losses without eliminating the opportunity for possible returns. Most traders use a combination of tools and practices to manage their risk exposure. Key considerations might include:

• Position sizing: Avoid overexposing your account. Larger positions increase the risk of significant losses from even minor price changes.
• Diversification: Spread your trades across different assets, sectors, or regions to reduce reliance on a single market.
• Defined exit strategy: Set clear rules for when to exit losing or profitable positions, using stops and limits.

While no strategy can eliminate risk entirely, a structured approach could help you trade with greater focus and discipline.

The leverage ratio measures how much you can borrow from the broker compared to how much margin you have to deposit. The ratio will differ depending on the market you’re participating in, the size of the positions you might want to take, and the trading broker you use.

The market conditions of an underlying instrument will also depend on the leverage you have available. A highly volatile market with low liquidity might only have low leverage available to protect you from quick price changes.

At the same time, if a market experiences high liquidity, you might have more leverage available because there are more market participants.

To put this in context, let’s use the earlier example again. You want to open a trade on AUD/USD at a value of $20,000 at a leverage ratio of 20:1. This means you’ll only need $1,000 of margin to open the position.

It might also be essential to remember that some geographical locations have their own set of leverage ratios for various market instruments. Australia, for example, has a leverage ratio of 30:1 for forex trading.

Depending on the broker you use, you might be able to see the leverage ratio available on your account.