Leverage is a useful tool to increase the amount one can trade despite their own limited capital. As long as you can meet the broker’s margin requirements, the broker will offer leverage of up to 1:500. Read about leverage is in our guide.
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If you trade with a broker that offers contracts for difference (CFDs) for derivatives such as forex, cryptocurrencies, stock equities and commodities, then chances are you will be trading using leverage. Leverage is a way to trade with a significantly larger volume than would otherwise be possible with the limited trading capital you have available. When investments go in your favour, leverage can amplify your profits, so is a useful trading strategy.
This article looks at what leverage is, along with its benefits and risks.
Leverage simply means taking on debt (usually for investment purposes) and presents an alternate way of accessing funds to using equity or selling. In business or finance, leverage can assist with financing the purchase of assets such as inventory, equipment or investments or increasing working capital in order to manage cash flow. Taking out a loan or issuing bonds means the business does not give up ownership while allowing the business to grow or function. In personal finance, it can mean taking out a mortgage to purchase a home, taking out a student loan to pay for one’s education or a car loan to purchase a vehicle.
When people refer to using leverage to acquire something, they are really saying they are going into debt by borrowing funds to acquire or resolve a need.
Leverage means borrowed capital
In the investment world, the meaning of leverage has a slightly different meaning. Leverage for investment involves ‘buying on margin’ which means you are using borrowed money to increase returns through investments. Investment can be through different types of products in the financial markets such as stocks, forex, bonds, funds, exchange-traded funds, options, commodities, cryptocurrencies, and even their contract for difference (CFD) equivalents.
Leverage allows you to open positions beyond the limitations of your available account balance. To access leverage, you need to ensure your trading account balance has enough free funds to use as an initial investment to meet the required margin of the broker. This is why the use of leverage when trading is sometimes referred to as margin trading.
The advantage of using leverage is that it increases your purchasing power and therefore the potential profits you can earn for only a small outlay of your own capital. While leverage can increase profits, it can equally amplify losses should the value of the investment move in an unfavourable direction.
Leverage in investments means using borrowed capital to amplify potential returns
In the forex market and CFD trading prices don’t tend to fluctuate more than 1% throughout the intraday period. With a fluctuation of less than 1%, it can be difficult to achieve large profits, so this is why brokers offer forex leverage. In Forex trading, pip movements between currencies don’t change significantly except in unusual economic events, so the profit for each trade tends to be minor.
In order to make profits, you need to either invest substantial amounts of your own cash (which most traders don’t have available) or use leverage. With leverage, pip movements of greater than 10% can be achievable and this can lead to a vastly improved opportunity for good profits.
Leverage is usually expressed as a ratio between the amount you invest and the amount your investment will be amplified. The ratio is usually expressed as 1:Leverage.
CFD and Forex Brokers will advertise the maximum amount of leverage you can trade with however some brokers may use margin requirements. Margin is is the fraction of money you need in your trading account to open a position for each trade, while leverage is the amount of money, the broker will lend for each dollar you deposit. While leverage is expressed as a ratio, the margin is expressed as a percentage (%) in place for use.
The below table shows the relationship between leverage and margin.
Leverage and margin requirements for each broker will differ, however, it is common to find that brokers will offer the maximum margin that is permitted by the national financial regulator. The below table shows the maximum available leverage for a selection of instruments with a range of regulators.
Leverage of above 50:1 is becoming less common with 1st level regulators as regulators seek to protect retail investors from significant losses. High leverage is mostly found with offshore regulators such as those found in Belize, Seychelles, Vanuatu, and Bermuda or with brokers that have no regulations. These brokers have more relaxed regulations so may present a high risk for retail trader’s savings as brokers are not required to have the best trading, financial or risk, and security practices.
Traditional leverage ratios include
As you can see, the larger your trade size or the more standard lots one trades, the more margin will be needed
While leverage has the big benefit of allowing one to trade with less of their own capital to increase to opportunity for greater profits with small currency fluctuations, one must be aware of the downside of leverage. When price movements work in your favour, you can amplify your gains, however, if price movements go against you, your level of expertise can be amplified.
This is why leverage should be used as a conservative strategy, large losses mean large debts and these can be difficult to repay. The carry trade strategy is one of the few trading strategies that allows retail traders to take advantage of high leverage ratios.
Leverage should be used responsibly and strategically. It is a good idea to use leverage alongside a good risk management strategy. Professional traders for example will often trade with a very low level of leverage. Just because your broker offers leverage of 1:500 does not mean you need to use all the available leverage. Low leverage helps minimise any financial pain from trading mistakes or unexpected volatility in prices.
Most tier-1 regulators Australia Securities Investment Commission (ASIC), Financial Conduct Authority (FCA), ESMA (all European regulators such as BaFIN and CySEC) limit the available leverage a broker can offer retail investors to 30:1 for major forex pairs (such as EUR/USD, USD/JPY, AUD/GBP) and 20:1 for minor and exotic currency pairs. This is because they wish to protect retail investors from large losses, as it is considered these traders don’t have the necessary level of experience to use leverage properly.
While retail investor accounts have restricted leverage, some regulators allow professional forex traders to access higher leverage provided they can show they meet 2 of the following requirements:
These requirements will vary for each regulator.
Using leverage can mean you are vulnerable to large losses however you can protect yourself with risk management tools. Example of risk management tools include:
These tools are designed to ensure protect your account from debt when currency movements change against you or your account funds are running low. One important detail to be aware of is that with the exception of a guaranteed stop-loss (which can be costly) none of these tools will protect you in the event of slippage.
Leverage is a useful tool for traders, as it has the potential to amplify profits when trading that might not otherwise be achievable. This is because it gives you access to a larger amount of capital to trade with than you have, and this increased capital can help outsize your earnings despite small market movements.
While it might seem tempting to use the leverage for quick and large gains, one must keep in mind, that leverage can also increase losses. This is why it is critical to use leverage responsibly, leverage is a complex instrument so it is wise to use only the leverage you need and use risk management tools where possible. When using leverage, the golden rule is to only trade with what you can afford to lose. Happy trading.
Justin Grossbard has been investing for the past 20 years and writing for the past 10. He co-founded Compare Forex Brokers in 2014 after working with the foreign exchange trading industry for several years. He also founded a number of FinTech and digital startups including Innovate Online and SMS Comparison. Justin holds a Masters Degree and an Honours in Commerce from Monash University. He and his wife Paula live in Melbourne, Australia with his son and Siberian cat. In his spare time, he watches Australian Rules Football and invests on global markets.