Leverage Trading: How It Works & Risk Management

In trading, leverage is additional buying power that brokers offer investors on the financial markets. Yet most traders do not fully master how to do leverage trading. Discover in this article everything you need to know about leverage trading.

What Is Leverage? Definition

Leverage is a financial mechanism that amplifies gains (but also losses) by using borrowed funds to make a larger investment than the trader’s or investor’s own capital would allow.

In other words, leverage allows you to control a larger position with a smaller amount of capital. For example, with a leverage of 10:1, an investor can control a position of €10,000 with only €1,000 of their own capital.

If the investment generates a profit, leverage multiplies that gain. However, in the event of a loss, the loss is amplified too, and the investor could lose more than their initial investment. That is why leverage carries significant risks and requires careful management.

Leverage Formula

Leverage = Total position value / Required margin

If you open a position of one EUR/USD lot (total value of $100,000) and the required margin is $1,000, the leverage will be 100.

EURUSD Leverage Trading Example

• You have a trading account with initial capital of $1,000.
• You choose a leverage of 100:1.
• The current price of EUR/USD is 1.1000 (that is, 1 euro = 1.10 dollars).

You buy 1 standard lot, which is equivalent to 100,000 units of EUR/USD.

Maximum Leverage:

Maximum leverage is the level of leverage you can use in a transaction according to the conditions of your broker or trading platform, or according to market regulation. It represents the maximum you can borrow to open a position relative to your capital.

• Example: If a broker offers a leverage of 200:1, it means you can control a position up to 200 times larger than your own capital.
• Imposed limits: Regulations can cap maximum leverage, especially on riskier markets such as forex or cryptocurrencies. For example, some regulators impose a maximum leverage of 30:1 or 50:1 on certain currency pairs or financial instruments.

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Effective Leverage:

Effective (or real) leverage is the leverage you actually use in a transaction, based on your capital and the positions you take. It takes into account not only the size of the position, but also the actual use of margin and capital.

Effective leverage = Total position value / Margin

• Maximum leverage is the theoretical maximum leverage capacity you can use according to your broker or regulation.
• Effective leverage is what you actually use in a particular transaction, based on the amount of margin you deposit and the size of the position you open.

In short, maximum leverage is the limit you can reach, while effective leverage depends on your trading decisions and on how much capital you put at stake in each position.

Calculation – Total Position Value with Leverage:

• • A standard lot on the currency market represents 100,000 units of EUR. If you buy 1 lot of EUR/USD, you buy 100,000 euros.
  • So, the total value of the position is:
    100000 EUR×1.1000 (EUR/USD price)=110000 USD

You therefore control a position worth $110,000.

Required Margin with a Leverage of 100:1:

• With a leverage of 100:1, you only need to deposit a fraction of the total value of the position to open the trade.
• The required margin is therefore: 110000 USD/100=1100 USD ​ = 1100 USD
• You therefore need to deposit $1,100 to open this position of 1 lot.

Profit and Loss Scenarios with Leverage:

• If the price of EUR/USD rises:
  Suppose the price of EUR/USD moves up to 1.1050 (an increase of 50 pips).
  • A move of 50 pips (1 pip = 0.0001 for EUR/USD) on 1 standard lot represents $500 (100,000 units x 0.0005 = $50 per pip, multiplied by 10).
  • You therefore make a profit of $500.
• If the price of EUR/USD falls:
  Suppose the price of EUR/USD drops to 1.0950 (a fall of 50 pips).
  • You suffer a loss of $500.

Margin Calls and Leverage

• Margin call: This happens when the value of your position falls and your capital becomes insufficient to keep the position open. The broker then asks you to deposit additional funds to avoid the liquidation of the position.
• The higher the leverage, the greater the risk of a margin call, because even small movements in the price of the asset can significantly affect the value of your position.
• If the market moves against you and the remaining margin becomes insufficient, a margin call will be triggered to restore your capital and keep the position open.

Leveraged Financial Instruments

Here is a list of financial instruments that can be used with leverage:

1. Forex (currency market) : Trading on the currency market allows the use of high leverage. For example, a leverage of 100:1 is common on the currency market, which means a trader can control a position 100 times larger than their initial capital.
2. Contracts for Difference (CFDs) : CFDs allow you to speculate on the rise or fall of an asset without owning the underlying asset. They usually offer significant leverage, sometimes up to 30:1 or more, depending on the asset.
3. Options : Options provide leverage by allowing the investor to control a larger position than with a direct purchase of the underlying asset, while limiting the loss to the premium paid.
4. Futures (forward contracts) : Futures contracts allow you to buy or sell an asset at a specified price at a future date. They are often used with leverage, because a small initial deposit (called margin) is enough to control a much larger position.
5. Stocks on margin : Buying stocks on margin means borrowing money from a broker to buy more shares than you could with your own capital. Leverage can amplify gains, but also losses.
6. Leveraged exchange-traded funds (ETFs) : Some ETFs are designed to provide leverage by tracking indices with a multiple of their performance. For example, a 2x leveraged ETF seeks to double the returns of the underlying index.
7. Cryptocurrencies : On some cryptocurrency trading platforms, investors can use leverage to buy larger crypto-asset positions, sometimes up to 100x.
8. Contracts for Difference (CFDs) on crypto-assets : Like traditional CFDs, these contracts allow you to speculate on the prices of cryptocurrencies without actually owning them, while using leverage.
9. Commodities : Commodity futures (oil, gold, etc.) can be traded with leverage, which allows you to control a large position with a relatively small initial outlay
10. Forwards (non-standardized forward contracts) : Forward contracts are similar to futures, but they are traded over the counter (OTC), that is, directly between the parties, without going through an exchange. They allow you to commit to buying or selling an asset at a future price. Forwards also offer the possibility of using leverage, although this is less common than with futures, depending on the terms of the contract.

These instruments allow investors to amplify their potential returns, but they also carry considerable risks, especially in the event of adverse market movements.

Leverage Vocabulary:

• Leverage : Lets you control more assets with less money.
• Effective leverage : The leverage you actually use in a transaction.
• Margin : The capital you must deposit to open a position.
• Lot : Unit of measurement of a transaction (e.g. 100,000 units for a standard lot).
• Own funds : The money you invest yourself in the transaction.
• Margin call : A request for additional funds if the value of your position falls too low.

Leverage Trading – Leverage and the Concept of Margin

Leverage and margin are two closely related concepts. The latter refers to the portion of your own capital invested in the position. You therefore understand that it is necessarily closely tied to leverage. As an illustration, take the example of a person who invests €1,000 in a position. If the leverage is 20 (or 1:20), their commitment must total €20,000 (5%). Below, discover how the two concepts are linked.

The thresholds shown above are not the same if you use a professional account. With certain assets such as gold and silver, they can climb as high as 1:500.

Why Do Leverage Trading?

Trading with leverage can offer several advantages, but also risks. Here are some of the reasons why traders choose to use leverage:

• Increase potential returns: Leverage lets you control a larger position with a smaller amount of capital, which can amplify gains if the market moves in your favor. For example, a 1% gain on a leveraged position can translate into a 10% gain if you use a leverage of 10:1.
• Exploit opportunities with limited capital: Leverage allows traders to access more expensive markets or assets (such as stocks or currencies) with less of their own money, which lets them take more positions or explore more trading opportunities.
• Optimize capital management: By using leverage, a trader can deploy their capital more efficiently, taking several positions with smaller amounts of funds while controlling a larger value of assets.
• Diversification: Using leverage makes it possible to take several positions across different assets while keeping overall capital under control. This can provide more diversification in the trading portfolio.
• Risk hedging: Traders sometimes use leverage to hedge another position. For example, if a trader holds a position on one currency, they could use leverage to take an opposite position on another asset, in order to limit risk.

Beware of the Risks:

Leverage amplifies potential gains, but also losses. If the market moves against the position, losses can exceed the initial investment, which makes good risk management essential.

In short, leveraged trading can deliver higher returns and help maximize the use of capital, but it requires careful risk management.

Leverage Trading – Regulation for Retail Traders

Regulation for Professional Traders

It was ESMA that, in 2018, set leverage limits by asset class. The European Securities and Markets Authority (ESMA) is responsible for supervising the financial markets in Europe. The French financial markets authority (Autorité des marchés financiers, AMF) applies ESMA’s regulations.

Leverage Trading – Which Level Should You Choose?

• The principle you should follow is progressivity. If you are new to leveraged trading, it is advisable to choose beginner-friendly trading leverage. You should not start out using high leverage.
• For stocks, commodities and stock indices, if the highest leverage is 5, 10 or 20, it is best to opt for the lowest one. You may choose a leverage of 2 if you start out trading stocks.
• If you are an experienced trader, you can run your investment with significant leverage. Once you have gained experience, you can proceed to open a professional account. The conditions for accessing one vary from broker to broker. In most cases, however, they are stringent.

Leverage Trading – Is It for Me?

Leveraged trading is not suited to everyone, as it presents both opportunities and high risks. Here are some criteria to consider to determine whether leverage trading is for you:

Risk Tolerance

• If you are comfortable with risk: Leverage amplifies gains, but also losses. If you have a high risk tolerance and are prepared to accept the possibility of substantial losses, leveraged trading could suit you.
• If you are risk-averse: If you prefer to minimize risk, leverage may not be for you, as losses can exceed your initial capital.

Trading Experience

• Advanced experience: Leverage is often used by experienced traders, as it requires a thorough understanding of the financial markets and of risk management.
• Beginners: If you are new to trading, it is recommended to start with unleveraged transactions or with low leverage until you are more comfortable with the markets.

Ability to Manage Emotions

• Stress management: Leveraged trading can cause rapid swings between gains and losses. If you are able to stay calm and rational during periods of volatility, leverage could be an option.
• Emotional reactivity: If you tend to react impulsively to market movements, leverage could be risky for you, as it can lead to rapid and substantial losses.

Financial Goals

• Short-term goals: If you are looking for quick gains on short-term market movements, leverage can help you maximize those opportunities.
• Long-term goals: If you have a long-term investment objective, leverage may not be necessary and can increase risk without delivering lasting benefits.

Capital Management

• Ability to manage positions: You must be able to monitor your positions regularly and adjust the size of your trades. If you are able to manage your margin, calculate the appropriate leverage and limit losses, leverage could suit you.
• Risk budget: If you have a defined risk budget and can afford to lose part of your capital without jeopardizing your finances, leverage can be considered.

Using Risk Management Tools

• Stop-loss and take-profit: Using tools such as stop-loss orders (to limit losses) and take-profit (to lock in gains) is crucial in leveraged trading. If you are ready to incorporate these tools and define clear exit strategies, leverage may be appropriate.

Regulation and Broker Conditions

• Leverage regulations: Some brokers offer higher leverage than others, depending on local regulations. If you are in a region where leverage is capped (for example, 30:1 on forex in Europe), this may influence your decision.
• Trading conditions: Always check the fees, the required margins and the broker’s specific requirements before you start trading with leverage.

Conclusion:

Leveraged trading is suitable for those who have:

• A high risk tolerance.
• Trading experience and a good understanding of the financial markets.
• The ability to manage emotions and react rationally.
• Clear financial goals and sound capital management.

If you meet these criteria and are prepared to take calculated risks, leverage trading can be an interesting option to maximize your returns. Otherwise, it may be better to start with more conservative strategies.

Volatility and Leverage

The volatility of the underlying asset plays a crucial role in the use of leverage. Here is how the two factors interact:

• Volatility: Volatility refers to the magnitude of an asset’s price movements over a given period. A more volatile asset will see larger price swings, while a less volatile asset will move more steadily.
• Leverage: Leverage lets you control a larger position with a smaller amount of capital. For example, with a leverage of 10:1, for every $1 invested, you control $10 of position.

The Effect of Volatility on Leverage

• Enhanced gains with high volatility: If an asset is very volatile, rapid price movements can generate significant gains for a trader using leverage. For example, a small move in the price of a volatile asset can produce substantial profits if the position is amplified by leverage.
  • Example: If EUR/USD rises by 50 pips (0.0050) and you use a leverage of 100:1 on a standard lot, you could earn $500 (50 pips x $10 per pip).
• Increased risk with high volatility: Volatility can also increase risk, because large price swings can quickly turn a trade against your position. This amplifies losses in the event of an adverse move.
  • Example: If the price of the asset drops by 50 pips in a volatile market, your loss will also be amplified, all the more so with high leverage.

High Leverage + High Volatility = Higher Risk

• When you use high leverage on a volatile asset, your gains can be significant, but the risks are amplified too. A small adverse move can lead to rapid losses, sometimes exceeding the initial outlay.
• Example: If a volatile asset swings by 5% in a day and you use a leverage of 10:1, this can translate into a 50% loss of your capital if the market moves against you.

Low Leverage + Low Volatility = More Manageable Risks

• If an asset is not very volatile, you can use lower leverage while maintaining reasonable return potential with controlled risk.
• Example: In a stable market, lower leverage (for example, 2:1) can be enough to generate gains while minimizing the risk of significant losses.

Managing Risk According to Volatility

• Adapt leverage to volatility: It is often wise to adjust leverage according to the volatility of the asset. If the asset is highly volatile, it may be sensible to use lower leverage, and vice versa.
• Using stop-loss orders: To limit losses during periods of high volatility, using stop-loss orders is crucial to protect your capital.

Conclusion:

• High volatility can offer opportunities for significant gains with leverage, but it also increases the risk of substantial losses.
• Low volatility and more moderate leverage can reduce risk, but limit gains.
• It is essential to manage risk (for example, with stop-loss orders) and to adapt leverage to the volatility of the underlying asset in order to maintain a good balance between return and risk.

Read next: CFD Trading – Explanation, Guide and Tips

Risk Management & Leverage

Leverage can offer great opportunities, but it also increases risk, and rigorous risk management is essential to protect your capital. Here are the key elements for managing the risks associated with leverage:

• Stops : A stop lets you limit losses by setting an automatic closing price if the market moves against you. However, in highly volatile conditions, your stop may not be triggered exactly at the desired value, which can lead to larger losses if the market moves too quickly.
• Guaranteed stops : Guaranteed stops work like standard stops, but they are guaranteed to trigger at the exact level you set, even in the event of a gap (the difference between two consecutive prices) or slippage (the difference between the expected price and the execution price). This gives you extra protection, but additional fees may apply on top of standard transaction fees.
• Limited-risk products : Limited-risk products, allow you to limit your losses to your initial deposit or to the notional value of the product. For example, when buying options, your maximum loss is limited to the premium paid for the option. Conversely, selling options exposes you to risks similar to traditional positions, with a theoretically unlimited risk if the market moves against you.
• Negative balance protection : In Europe, regulation guarantees that you cannot lose more than the capital available in your account. If your balance turns negative following substantial losses, your account will automatically be reset to zero, at no extra cost to you. This protects you against losses exceeding your initial investment, even if the market moves strongly against your position.

This article has an educational purpose and does not constitute investment advice. Leverage amplifies losses as much as gains.