What Is Leverage?
Leverage is the use of borrowed capital to increase the potential return of an investment. In trading, it allows investors to open larger positions than their account balance would normally permit. While leverage can amplify profits, it also increases the risk of significant losses, making it a powerful but potentially dangerous tool when not managed properly.
Key Takeaways
- Leverage enables traders to control larger positions with a smaller amount of capital.
- It amplifies both potential gains and potential losses.
- Common in forex and CFD trading, leverage is expressed as a ratio (e.g., 1:30, 1:100).
- Leverage can help maximize returns but requires strict risk management.
- Regulatory bodies often set maximum leverage limits to protect retail investors.
How Leverage Works
Leverage works by allowing a trader to borrow funds from their broker to increase the size of a trade. For instance, with 1:100 leverage, a trader can control $100,000 worth of assets with just $1,000 in margin.
In forex trading, this means you can gain exposure to large currency positions with limited capital, making the market accessible even to small retail traders. However, if the trade moves against you, losses are calculated on the full leveraged amount—not just your initial margin.
Examples of Leverage
- A forex trader uses 1:50 leverage to trade $50,000 worth of EUR/USD with only $1,000 in their account.
- A CFD trader opens a position on gold using 1:20 leverage, magnifying both profits and potential losses.
- A stock investor on a margin account borrows money from a broker to buy more shares than they could afford with their own funds.
Benefits of Leverage
- Increased Market Exposure: Control larger positions with less capital.
- Potential for Higher Returns: Amplifies profits on successful trades.
- Capital Efficiency: Frees up funds for other investments.
- Accessibility: Enables small investors to access major markets.
Costs and Limitations
- Magnified Losses: Losses are amplified just like profits.
- Margin Calls: If equity drops below a certain threshold, brokers may liquidate positions.
- Interest Costs: Borrowed funds may incur financing charges over time.
- Regulatory Caps: Some regions limit maximum leverage for retail traders.
Who Uses Leverage?
Leverage is commonly used by forex and CFD traders, institutional investors, and hedge funds. While it offers the potential for greater returns, it’s best suited for experienced traders with solid risk management strategies. When used wisely, leverage can be a valuable tool—but misused, it can lead to significant financial loss.