What is Leverage in Trading? - Margin and Risks Explained
By Stefano Treviso, Updated on: Apr 07 2023.
Leveraged trading consists of trading with borrowed capital from your broker in order to enhance your buying power. When a broker gives you a leverage factor (multiplier) of 1:10, 1:20 or any other, they’re referring to the amount of times that you’re buying power is amplified to. Brokers offer leverage at a cost based on the amount of borrowed funds you’re using and they charge you per each day that you maintain a leveraged position open.
Leverage can be either very good or very bad for you as a trader if you don’t know what you’re doing, this guide can save you a lot of trouble as you’ll understand literally everything there is to know about leverage. Here’s what we’ll talk about during our guide:
- What is Leverage in Trading?
- What is Margin in Trading?
- How to Calculate the Required Margin for Trade?
- How Leverage Works in Trading
- What is the Cost of Trading with Leverage?
- How to Trade with Leverage
- Example of How to Trade with Leverage
- Conclusion
- Frequently asked questions
What is Leverage in Trading?
Leverage is the exact amount that you’re buying power has been amplified to. For example, if you broker tells you that you have leverage of:
- 1:10 - This means that each dollar you have, gives you the buying power of $10.
- 1:20 - This means that each dollar you have, gives you the buying power of $20.
- 1:30 - This means that each dollar you have, gives you the buying power of $30.
- 1:400 - This means that each dollar you have, gives you the buying power of $400.
So, if you have $1000 in your trading account and your broker offered you 1:20 leverage, that means that you can trade with $20.000.
I know the first thought that is coming to your mind, who the hell would lend me $20 or $400 per dollar that I have? Well, take it easy, there’s a big catch in all of this so don’t be in a hurry.
Now that we’ve established what the leverage factor number is, we need to start with our first example that will lead us to ask the right questions to move on through the guide.
If you want to open a trading position worth $100.000 and your leverage is 1:50, how much money do you need to do that?
You need $2000 and that sum of money is called MARGIN, we’ll teach you how it is calculated.
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What is Margin in Trading?
Margin is the required amount of funds to open and maintain a trading position. Think of it as the cash you’re putting upfront to guarantee what you’re doing in case it goes wrong.
If you’re right and your trade goes in your direction, no one cares and everyone is happy. But if you’re wrong, there’s got to be something answering for the price fluctuations of your investment and that’s why we call margin a “requirement”, without it, you can’t open or keep open your trading position.
How to Calculate the Required Margin for Trade?
To calculate the required margin for a trade you need to divide your trade’s worth (in dollars) by your leverage factor, here’s a visual formula:
Using the formula above let’s do a quick example of a margin calculation:
- You want to purchase $50.000 worth of oil.
- Your leverage is 1:10.
- If we divide $50.000 by 10, the result is $5000.
- Your required margin to open the position is $5000.
That MARGIN is the upfront cash that backs your position, meaning that in this example, those $5000 answers for the price fluctuations of your investment worth $50.000.
This last sentence is the difference between life and death for a newbie trader, so read it several times and then later during the guide you’ll see why I said this.
How Leverage Works in Trading
Now that we know what the leverage factor is, the margin and how to calculate it, let’s get into the logistics behind all of this.
If leverage amplifies your buying power then ask yourself this question: who’s giving you that possibility and why would they do that?
Your broker does this and they do it for two different reasons:
- You’ll open bigger trading positions and this generates more commissions or fees for them (this is the honest brokers approach).
- You’re likely to make more mistakes and lose money faster. Before you made a mistake with $1 then that mistake could be amplified by $400 and for brokers that profit from trader loses this is THE DREAM. (Read our guide on how brokers make money to understand this better).
Ok, so now you know who gives the leverage and why they have an interest, but what about the cost of using this service? (I know, it's an irony, even though some brokers give you this service so you lose more money faster, they still charge you for it).
What is the Cost of Trading with Leverage?
Whenever you open a leverage position, you’re going to pay an interest rate on those borrowed funds which is usually called the overnight fee.
Overnight fees are the cost of using lent funds by a broker to open a leveraged trade.
These fees are not calculated always in the same way for all assets and brokers can choose different forms of calculation if they wish.
Instead of boring you with complex calculations that won't really bring much benefit to you, what you need to know is that most brokers will display in their trading platforms the overnight fee for long or short positions.
In some cases this overnight fee can be either charged or credited in your favour.
Here's an example of how those fees are shown:
Those percentages refer to the total value of your trade, so if your trade is worth $50.000 then one of those percentages in the example is what you'll get charged for holding your position open overnight.
How to Trade with Leverage
To use leverage correctly you need a lot of patience and the ability to run some calculations yourself, unless you don’t mind going broke quickly.
Just because you have leverage and the ability to open huge positions doesn’t mean that you should, you need to think first if it’s reasonable.
Here’s the first questions you need to answer before opening a leveraged trade:
- How much capital do you have in your trading account?
- What’s your risk management strategy? How much are you willing to risk per trade?
- What’s the average movement of that asset per day?
- How quickly can you hit your stop-loss depending on the quantity you purchase of that asset and the average price movement?
The importance of these questions will come into light using a little bit of brokerage dark humour, for me leverage is one of the funniest subjects in finance, people tend to cling to irrational beliefs about the quantity or prices of their trades. I've heard comments like "I always buy 50, it's my lucky number". The moment I hear that, I really feel like giving up on everything, but then I remember that I'm fighting against this and keep pushing.
I’ve talked to so many new traders that just because they see that they can open a $80.000 position in oil using $200 of margin (when everyone used to have 1:400 leverage) they go for it thinking that they’ll go rich and well…. You know how this story ends.
They open the trade, one second passes and puff!! Trade closed, that monster $80.000 investment moved a few cents in its price and wiped those $200 in the blink of an eye, so please, don’t be this type of newbie trader.
In this comedy example I provided, oil is trading at $40, so that means that our newbie trader bought 2.000 barrels of oil worth $80.000 using $200 as margin.
Now this is very simple, how much does the price of oil need to move for him to lose 2.000$?
EASY! If you own 2.000 units of something and those units increase 1$ you profited $2.000, if they decrease $1 you lost $2.000.
All you need to do is multiply the quantity in units of what you own by the price change and this gives you an idea of how much you can lose or profit.
Now, again, how much does the price of oil need to change for that monster trade to wipe out $200?
BARELY $0.1, that’s all the movement needed.
So if oil moves at least $2 per day, WHY THE HELL would you open a trade where if the price moves $0.1 you lost your trading account?
No sense at all.
I know, you can feel a little bit of anger when you read this text as I pound the keyboard in rage, I just wish that this subject was clearly explained to beginners so they didn’t lose because of this.
My mission is to make trading fair. I want traders to have a fair chance and not lose by technicalities, if you win or lose may it be your battle against the markets, not a battle against misinformation provided by nasty brokers or fake trading gurus.
Sorry, rage attack completed, let’s go back into the issue using a visual example of the steps you need to follow and a clear calculation:
Example of How to Trade with Leverage
Here are the steps in the form of questions you could ask yourself:
- How much trading capital do you have?
- What’s your risk management plan?
In this particular case we have $10.000 and we're willing to risk maximum 1%, which equals a $100 maximum loss per trade.
The more times you can afford to be wrong, the better, this will give you the ability to stay longer in the game and execute your strategies without going broke in 2 trades only. The green number that says 100 times is to let you know how many times you can go wrong.
- What’s the average movement of the asset you’re going to trade?
In this example we’re using oil and after doing some research (these are example figures, not the actual one) we realised that oil has an average movement of $2 per day.
- How quickly I can hit the stop-loss of my risk management plan based on the average movement of the asset?
Well, now it’s time to do simple math, if you know the price moves an average of $2 per day then you know that if you buy 50 of that asset, you’re exposing yourself at either $100 profit or $100 loss per day.
And here’s where you should ask the questions:
- Does the quantity of what I’m going to buy fits my risk management plan or not?
- Does it match the amount of time I want to keep my trade open?
Last question is very important, if you wanted to keep your trade open for 5 days, then you know that if you purchase 50 barrels of oil you’re exposing yourself to hitting your stop-loss in a single day, so you probably won’t make it to 5 days unless you’re only going in a profitable direction.
If you noticed, there was no need to even look at the leverage during this exercise, the whole point was to tell you that you need to look at position sizing based on real numbers such as your account size, daily average movement of the asset's price, etc. Then you can use leverage as a tool to trade with less funds than required for your plan.
After this exercise we hope that everything makes 100% sense now, leverage is cool, but you gotta know how to calculate it within a plan to be able to use it, otherwise is the equivalent of skydiving without parachute, you’ll feel the awesome pleasure of flying but you’ll become mashed potatoes when you land, and trust that the bigger the leverage, the faster your landing.
Conclusion
After this guide, we're confident that leverage should be if not 100% at least 99% clear to you. Remember that this financial tool carries great risk/reward potential in the right hands and only risk in the wrong hands.
Brokers can come and give you all sorts of leverage factors and claim that this is amazing, but if you don't know what you're doing it can be a problem instead of an advantage.
Practise a lot using your trading platform on how to calculate correctly the right position size in combination with your leverage to ensure that your trade actually meets your risk management plan and you'll be at a much better place than before.
Last but not least, remember, if someone gives you a super powerful machine gun, that doesn't mean you MUST use it and fire all the possible shots, you still need to be wise about the power you've been given. Leverage is the same, be wise about it and you'll save yourself a lot of trouble while opening up to amazing opportunities.
Good luck!
Frequently asked questions
Does the overnight fee get charged even if I’m not using borrowed funds?
This question is really a funny one.
If you have $500 in your account and you open a trade with a value of $100 and your leverage was 1:10 meaning that you only used $10 of margin to do this, are you borrowing money or not?
Well, you’re not. But some brokers will still charge you the overnight fee on your leveraged trade and other brokers will charge you only when you actually exceed your trading capital in use for opening positions.
The last way makes sense and it’s the right way, but remember, brokers can do whatever they want, so a lot of them charge you regardless of it having no logic at all.
Their premise to do so is that you're only using $10 in margin and still have the other $490 as margin available to open leveraged trades.
Always double check these conditions with your broker.
What’s the effect of leverage on profits or losses?
Leverage’s effect on profit or loss is massive amplification of whatever you’ve done in the first place.
Leverage is the equivalent of trading on steroids or driving a massively supercharged car with 6 turbos. It can go super fast and make you win the race but if you crash at 500 miles an hour you’ll probably get killed.
If every action that you take is amplified by 20, 30 or 400 then that means that you can be 400 times right or 400 times wrong, that’s why a lot of people call it a double-edged sword.
Why did ESMA pass a law reducing the leverage offered to retail investors?
Everyone says that ESMA (European Securities and Markets Authority) did this to protect inexperienced traders from the risk of high leverage with little knowledge, but that’s not the whole truth.
Nasty brokers were using high leverage combined with crappy account managers that provide bad trading advice on purpose to make clients lose faster, as trader’s loses are these brokers profits on an individual basis.
ESMA’s strategy was to halt the number one cause for margin calls, high leverage, and that way they reduced the risk of retail investors, at least now its harder to get scammed than before…
As you know, not because a broker makes money from losses it's a bad broker, what makes them bad its when they provide bad advice or do bad stuff to cause traders to lose.
Fun fact, if you want to check the impact of ESMA on good market maker brokers all you need to do is look in google for the share price of CFD market maker brokers that are publicly traded and look the price drop during the year 2018, investors knew that brokers would make less money due to this laws so share prices dropped massively.
Leverage in Forex, is there any difference?
Not at all, there’s no difference. Leverage is leverage regardless which asset you’re using.
Do you have to use leverage when trading forex?
Not really and something quite funny, without leverage is mission impossible to lose a trading account in forex, it would take you years.
Some cfd brokers offer non leveraged trading, but that’s very rare as also to make any significant profits you would require a huge amount of capital.
What is a margin call?
Margin call is when you hit the maximum threshold in losses of your current position set by your broker or the regulator or legal entity that controls this matter.
For example, if the margin call threshold is 50% then if you have a trade that requires $2000 in margin to be opened, by the time you hit $1000 in losses, you just hit your margin call assuming you only had only $2000 in your account.
Your broker will either call you before that 50% is hit asking you to deposit more money or when you hit 50% you’ll get closed.
This is the number one tactic used by dirty brokers to make money, to put their clients on margin calls to make them deposit like crazy to keep open bad positions, usually these traders don’t use stop-loss orders and keep losing positions growing huge.
If I get a margin call which of my trading positions will get closed first?
I’ve seen it all on this one. The answer is, you never know as it depends on the broker.
Some brokers will close the ones that release the more margin possible, others will close everything.
You need to ask your broker which are their margin close out rules.
What is the maximum leverage for European Traders?
Thanks to the ESMA legislation, the maximum leverage for retail clients is 1:30.
There is another category of client called professional clients that can get up to 1:200 but you require to have experience or qualifications in the financial services industry, a portfolio of 500.000 Euros or certain academic qualifications.