Leverage in trading: how does it work?

Leveraged trading is the use of a smaller amount of capital to gain exposure to larger trading positions via the use of borrowed funds, which is also known as margin trading. It can magnify potential profits, but can equally increase losses, so trading and risk-management strategies should be used.

Understanding the difference between the two can sometimes cause confusion. It is important to realise that margin is the amount of capital that is required to open a trade.

A leverage ratio of 10:1 means that to open and maintain a position, the necessary margin required is one tenth of the transaction size. So, a trader would require $1,000 to enter a trade for $10,000. The margin amount refers to the percentage of the overall cost of the trade that is required to open the position. So, if a trader wanted to make a $10,000 trade on a financial asset that had a ratio of 10:1, the margin requirement would be $1,000.

Leverage can sound like a very appealing aspect of trading, as winnings can be immensely multiplied. But it is a double-edged sword – it is important to remember that losses can also be multiplied just as easily.

It is important for all traders to bear in mind the risks involved. Many traders see their margin wiped out incredibly quickly because of a ratio that is too high. Novice traders should be especially careful when practising margin trading. It is best to be more prudent and use a lower ratio. A lower ratio means traders are less likely to wipe out all of their capital if they make mistakes.

To start trading, it is advisable that a trader starts with a ratio that is lower than their maximum leverage allowance. This enables traders to keep their positions open for the full size, even if they are experiencing negative returns.

This type of trading is more likely to be adopted by those trading short-term price movements​. It would be much less suitable to anyone investing long-term, for example over multiple years or even decades. In this instance, a ‘buy and hold’ approach would be more suitable. In this instance, a ‘buy and hold’ approach would be more suitable.

For example, let’s say a trader has a maximum leverage of 5:1 and opens a position on Apple shares​ with that leverage on a $10,000 account. The trader now has a position size with an asset value of $50,000, which has given them trading exposure to 5 times as many shares when compared with if they had purchased the assets outright without leveraging their starting capital of $10,000. To maintain this leveraged position in Apple stock, the value of the trader’s account would need to stay above the maintenance margin requirement of 50%, or 5,000 in this example.

Leveraged products are derivative instruments that are worth more on the market than the deposit that was initially placed by an investor. A leveraged product that we offer is contracts for difference (CFDs​​). When trading with leverage on CFDs, an investor can place a bet using a reasonably small margin on which way their chosen market will move. The investor technically does not own the underlying asset, but their profits or losses will correlate with the performance of the market.

CFD traders will have to pay a commission charge in addition to the spread when trading shares. To calculate your profits or losses, you must find the difference between the price at which you entered and the price at which you exited. For CFDs, it should be multiplied by the number of CFD units. Read more about our CFD commission rates​​​​ here, along with our article on CFD meaning​​​​.

An important aspect in using leverage is understanding how to calculate the ratio. The following leverage ratio formula is commonly used and easy to remember:

L = A / E

where L is leverage, E is the margin amount (equity) and A is the asset amount.

Therefore, dividing the asset amount by the margin amount gives the ratio of leverage.

It is also possible to start with the margin amount and apply a leverage ratio to determine the position size. In this instance, the formula would be A = E.L. Therefore, multiplying the margin amount by the leverage ratio will give the asset size of a trader’s position.

Most traders distribute risks across different markets, meaning they are not putting all their capital into one trade. This is done by opening various positions in different markets. When this is the case, there may be the need to do calculations to determine net asset value or the accumulative value of a trader’s positions. Thanks to platform technology that most brokers will offer, it is easier to monitor all parameters and open or close individual positions as needed. More importantly, it can help a trader work out if positions fit within their total leverage amounts, which should be less than the maximum leverage allowed by the broker.

As discussed, we have differing leverage ratios and margin rates for each type of financial market and asset. All products are available on our trading platform​​​, Next Generation, where you can put into place risk management tools, such as stop-loss​​​ and take profit orders. Familiarise yourself with our platform now by creating a live account, or practise first with virtual funds on a demo account, which is included for free upon registering. Take a look at our extensive list of charting features​​​​ here.

The most important thing to understand when talking about leverage is the risk involved. Risk is inherent to any type of trading, however, leverage can cause both magnified profits and losses. It would be prudent for traders to pay particular attention to choosing how much leverage they will use. The leverage ratio should be determined in advance of trading. It is very tempting to trade in a larger size than what was originally determined if you have a streak of winning trades.

Doubling your risk on a one-off basis could benefit a trader if they happen to get that one-off trade right. But get it wrong and a trader could end up facing a much larger loss than usual. To help reduce risks in trading, you should plan out your trading strategy​​​​ in advance.

Two factors could be taken into consideration when determining what amount of leverage to apply to a portfolio: how much risk to take per trade and how much risk to take per day. Examining this via percentages makes things easier. First, a trader can determine how much risk they are willing to take per day. This involves deciding the maximum amount that you are willing to lose. This could, for instance, be between 1% and 2%. If a trader were using 2% as maximum daily risk, it would take 50 days of bad losing trades in a row to wipe out their capital, which is hopefully extremely unlikely to happen.

A trader should also determine how many trades they want to place per day. This could be a set number or a maximum number. For example, a trader may decide that whatever the market, they will make a maximum of three trades a day. In each case, the trader can divide the percentage they are willing to risk per day by this number.

A popular risk-management tool to be considered when trading with leverage is a stop loss. By implementing a stop-loss order​​​ to your position, you can limit your losses if your chosen market moves in an unfavourable direction. For example, a trader may choose a pre-determined figure that they do not want to surpass, meaning that your stake in the instrument will be sold at the given price. However, please note that basic stop losses are susceptible to market gapping and slippage. Guaranteed stop losses​​​ work exactly in the same way as basic stop orders, although investors can choose to pay a small fee to guarantee the closing of a trade at the exact price specified. This way, if you have used a particularly high leverage in the trade, there will be less chance of multiplying your losses, regardless of market volatility.

Read more about how to protect your money in trading with our risk management​​​ guide.