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What is Leverage?

Trading is about taking advantage of small price movements in the market. However, to make the most of small price movements, you might need to enter a large position. This is not always possible, given that we usually have limited funds in our trading accounts. This is where leverage comes in. Leveraged trading has gained huge popularity, given that a September 2020 poll by Yahoo Finance-Harris showed that 43% of retail traders today use leverage. This is supported by a 2021 Deloitte report that revealed that today’s trader prefers to trade more frequently but tend to maintain smaller account balances than their predecessors.

So, what is leverage and does it really help traders? Read on to find out.

What is Leverage in Trading?

With leveraged trading, the trader borrows additional funds from the broker for their trade and returns those funds when they close their position. This allows them to enter into a much larger position than they have the funds for.

For example, suppose you have $1,000 in your trading account. Your analysis indicates a viable trading opportunity if you open a position worth $10,000. Depending on the leverage offered by your broker, you can choose to trade with leverage. If you don’t want to use all the funds in your account, you could take on leverage of 1:100, where for every $100 you put in, the broker will give the remaining amount to bring the total up to $10,000. This way, you get to open a position worth $10,000 by only using $100 from your trading account.

Leverage trading is often used by day traders, who attempt to make profits off very small price changes.

How Does Leverage Work?

Leveraged trading is also referred to as margin trading. To be able to qualify for leverage, you will need to deposit a specified minimum amount in your trading account. This amount is called “margin.” The margin is usually a fraction of the total value of a leveraged trade. The remaining amount is provided by the brokerage. This fraction of the total leveraged amount is called the leverage ratio.

What is Leverage Ratio?

The leverage or exposure ratio determines how much you can borrow from the broker. It refers to the value of the total trade against your margin. So, let’s use the above example again. If your broker offers a leverage ratio of 1:100, then with $100 in your account, you can borrow up to $10,000.

Let’s understand how leveraged trading works with another example. Suppose you want to trade 2,000 shares of a company, where the current market price is $10 per share. Here we are ignoring any brokerage charges applicable.

Example:

Let’s take the example of the EURUSD. A trader decides to invest $1,000 to open a position in the forex pair at the price of 1.1305. Now, if the price moves up 100 pips to 1.1405, the trader will earn $10 on the trade. On the other hand, if the trader decides to use leverage at a ratio of 1:100, they will be able to open a position worth $100,000 with their investment of $1,000. Now, if the currency pair moves up 100 pips, their profit will be add up to $1,000. So, with the same investment amount, the trader is able to increase their exposure 100-fold, which also multiplies their profits.

However, remember that if the price falls by 100 pips, the same magnification will be true of losses too. So, while the trader will bear a loss of $10 when they open a position worth $1,000 with their capital alone, they will face a loss of $1,000 when they open the above-mentioned leveraged position.

Also, regardless of whether you earn a profit or make a loss, you will need to return the money borrowed from the broker when you opened a leveraged position.

Why is Maintaining the Minimum Margin Important in Leveraged Trading?

To begin trading with leverage, you first need to open a margin account with a broker. This type of trading account requires you to maintain a minimum amount of funds at all times. This minimum amount can differ from broker to broker and might also depend on the leverage ratio you choose. Once your account is funded, you can borrow up to a certain percentage of the total trading amount, based on the leverage ratio. Just like any other loan, you will need to repay the amount lent by the broker to fund your position.

However, remember that the margin requirements and leverage ratios can change, based on changes in regulations in the jurisdiction you are trading from and the assets you are trading.

So, what happens if you don’t maintain the minimum required margin amount? You will receive a “margin call” from your broker. This is basically a notification to fund your account up to the minimum requirement. For instance, if the minimum margin requirement is $1,000 but the balance in your trading account falls to $800. You will receive a margin call to add money to your account to bring the balance back up to $1,000. If you fail to add the funds to your account, any trading positions opened on leverage will automatically be closed. Some brokers do so without requiring your approval to close the positions.

You will be responsible for any losses incurred due to such closures. The best way to protect yourself against margin calls is to use risk management measures, such as stop loss orders. It is also useful to keep track of your trading account, especially if you are using expert advisors or any other type of automated trading.

In Which Markets is Leverage Trading Used?

Leveraged trading is most popular in the forex market. Leverage is available for almost any financial asset that you can trade via contracts for difference (CFDs), including currencies, stocks, commodities and indices.

When trading certain market products, the prices of some of them may be high. This makes it difficult for many traders to enter and exit positions based on the funds in their trading accounts. The same is true for stocks of giants like Berkshire Hathaway, Apple, Alphabet, etc. With CFDs, which is a leverage trading product, traders can enter into positions without the need to own the underlying asset. They simply speculate on the future price direction of the asset via a contract. With leverage, they can enter into much larger positions and enhance their market exposure without requiring a lot of capital.

What are the Benefits of Leverage?

Leveraged trading is one of the most powerful tools used by traders. The advantages of using leverage include:

• Leveraged trading helps in magnifying profits. By investing a fraction of the total amount required, you can earn the same profit as you would be funding the entire position. This is because profits are calculated on the total value of your position and not the amount you deposited as margin. However, while profits can multiply with leveraged trading, so can losses. This is why leverage is often referred to as a “double-edged sword.”
• Since leverage trading helps in freeing up a lot of your capital, you can use your funds to diversify your trading portfolio. This is a great way to manage risk. The process of increasing the availability of capital for investments is referred to as ‘gearing’ and thus leverage trading helps with gearing opportunities.
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Are There Any Risks in Using Leverage?

As mentioned earlier, when you use leverage, your losses will be magnified, just like your profits. This is because you are trading using borrowed capital and if the market goes against your expectation, you lose your margin but may still need to pay the broker back the borrowed capital used to open the position. So, while opting for leverage trading, it is useful to consider the total value of the trade and not just the initial capital you put in. The downside risk also needs to be evaluated to minimise the losses.

One way in which regulated brokers protect traders is by offering negative balance protection. This means that you will never lose more money than you have deposited in your trading account. Regulatory bodies across the world, including the UK FCA, require brokers to ensure negative balance protection for their clients. However, remember that not all brokers offer this protection.

Having said that, you can also take charge of managing risks by using powerful tools for analysis before entering a trade and putting in place appropriate risk management measures. We will come to that shortly. Before that, let us tell you how you are already protected via leverage limits.

How Does Vantage Protect Traders During Leveraged Trading?

Vantage strictly complies with regulations in every jurisdiction in which it offers its services. The regulatory bodies across different countries have put guidelines in place to protect the interest of traders. Limiting the amount of leverage is one such measure. For example, as per the current regulations of the Financial Conduct Authority (FCA) of the UK, firms that offer leveraged trading via CFDs and similar instruments to retail traders need to limit the leverage ratio between 30:1 and 2:1, based on the volatility of the underlying asset.

Then, if a trader’s account balance falls below 50% of the margin required to keep positions open in leveraged trading via CFDs, the brokerage may close out the position on its own.

The FCA also provides protection by limiting the maximum loss to the total funds in the trader’s account. One of the ways this is done is via negative balance protection, as mentioned above.

Why Leverage Ratio of 1:30?

A leverage ratio of 1:30 or 30:1 is the highest leverage ratio permitted by the UK FCA. For professional traders and businesses, the leverage can go up to 500:1.

The FCA has limited the leverage ratio for retail traders because this group of traders usually has lower experience and capital than institutional traders. So, the losses that they can bear are also lower than professional traders.

Here’s an example to show how the losses can be magnified with higher leverage.

Example:  

Initial outlay = $1000 (margin)

Current price of asset = $10

	Leverage Ratio of 30:1
Total value of your position can be up to	$1,000*30 = $30,000
Total position (units)	3,000
Price goes up $12 – Profit	$2*3,000 = $6000
Price goes down $9 – Loss	$1*3,000 = $3,000

Another way in which traders are protected is through the Financial Services Compensation Scheme (FSCS). This is a deposit protection and compensation fund for investors in the UK. Under the current FSCS regulations, traders are eligible to receive up to £85,000 on their individual trading accounts from their broker if the firm fails.

How to Protect Yourself Against the Risks of Leveraged Trading?

To limit the risks associated with leveraged trading, there are certain risk management tools you can use.

You can use stop loss orders to restrict your losses. With a stop loss, you predetermine the price at which your position will get closed. Suppose you have opened a position worth $1,000, using $100 as margin and leverage of 10:1. Now, you determine that you can bear a loss of up to $20. So, if the current price of the asset is $5, you set the stop loss at $4.90. If the price reaches $4.90, your position will be closed.

Another type of stop loss order is the Trailing Stop, which allows traders to continue to earn profits while the market is moving in their favour. Here, the stop loss level will move as the price moves in the trader’s favour and automatically close the position when this trend reverses.

Similarly, you can lock in profits with take profit orders as well. If you predict that a rising trend might reverse at some point in the future, you can determine the price to which the asset can rise before your position is closed.

A Final Word

Leverage can be very useful for traders as long as you use it carefully. Arm yourself with the right tools to analyse the markets, and open an account with a regulated broker who offers excellent order execution and a regulated trading environment. Don’t forget to learn about all the risk management measures that can help you, and lastly, keep emotions out of trading decisions.

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