What is leverage in trading — how does it work?

Leverage in trading is a strategy traders could use to gain more exposure in 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 get the profits from the position or you'll have to 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 different ways. For example, professionals or traders who are more risk-inclined will use higher leverage, whereas conservative and inexperienced traders will likely use lower leverage.

However, the risks involved with leveraged trading are something every trader should take into account. The reason is that trading with leverage could potentially wipe out your entire margin deposit fast if you're not cautious or don't have a good risk 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 GBP/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.

We'll use the identical amounts and leverage ratio we calculated above for this example. A trader predicts GBP/USD is going to 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 say the trader was correct in their prediction, and GBP/USD fell by 5%; they would've made a profit of £1,000. However, if they were incorrect in their prediction and GBP/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 GBP/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.

In case your account experiences a certain amount of losses, the broker will send out a margin call notification. What this means is that the margin amount has fallen below the required margin 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 stocks/shares, forex, or indices. Let's take a look at each of these in more detail below.

Leverage in stocks/shares

Stocks or shares 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 to lesser-known stocks called penny stocks.

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

Leverage in forex

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 some forex pairs are generally minimal. However, these small movements through leverage can have a significant impact on either your profits or losses.

Leverage in indices

Indices are a representation of a group of assets and their performance from a particular exchange, sector, or region. Some of the most popular indices to trade include the Dow Jones 30, S&P 500, and FTSE 100.

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

Trading with leverage can be a powerful tool if used correctly and with caution. With that said, trading with leverage offers some benefits, so let's look at what some of those benefits are.

• Leverage allows traders to trade more expensive instruments set at premium prices, which would otherwise have been difficult for many traders to participate in.
• Market volatility is something every trader has to deal with. Participating in a highly volatile market is ideal for most traders because of the constant price movements. In contrast, low-volatile markets have less constant price movements. With that said, in low volatile markets, traders could gain profits 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, risks are always involved in trading. Let's look at some risks that might occur in trading with 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 have to keep in mind is a margin call. As mentioned above, when the trade starts going against you, there is a chance your losses could surpass your margin amount. In which 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 a fee.

The leverage ratio is used to measure how much you get to 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 GBP/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. The UK, for example, has a leverage ratio of 30:1 for forex trading, which is the same as Australia.

On the other hand, the Bahamas have a leverage ratio of 200:1, and the Seychelles have a leverage ratio of 500:1.

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