What is leverage?

Leverage enables you to enlarge your financial position and increase the potential return of a trade. With us, you can place leveraged trades on a range of financial markets, including:

• Forex

• Indices

• Shares

• Commodities

• Treasuries

• Exchange-traded funds (ETFs)

When you trade with leverage, you deposit a fraction of the full value of the trade to open a position. However, this form of trading amplifies potential profits and losses equally, making it riskier than traditional investing.

In this article, we explore what leverage is, how it works, and how you can use it to increase your exposure to around 11,000 instruments on our award-winning trading platform¹.

KEY POINTS

• Traders use leverage – essentially a loan from a broker – to increase their market exposure and potentially enhance their profits.

• When you open a leveraged trade, you deposit the margin (a small portion of the full value of the position) while your broker lends you the rest. That’s why the process is also known as trading on margin.

• The margin can be expressed as a percentage of the full value of a trade.

• Leverage amplifies profits on successful trades; equally, it amplifies losses on unsuccessful trades. Given the risks, traders need a risk-management plan.

What is leverage in trading?

Simply put, leverage is the use of borrowed money to enlarge your financial position and increase the potential return of a trade. When you trade contracts for difference (CFDs) with us, you speculate on the price movements of a given market without owning any underlying assets. When trading these products, you deposit the margin – a fraction of the position’s full value – while we put up the rest of the notional value of the position.

Leveraging your capital in this way amplifies potential profits and losses equally. This is because your profit or loss is based not on the margin – the amount you put up to open the trade – but on the full notional value of your position. As a result, trading with leverage, also known as trading on margin, means you could make large losses if the market moves against you. It’s therefore vital that traders put a risk-management plan in place.

How does leveraged trading work?

As we’ve just learned, when you open a leveraged trade you deposit the margin and your broker provides the rest of the position’s full value.

If the market moves in your favour, you make a profit based on the full notional value of the position. However, if the market moves against you, you incur a loss based on the full notional value of the position.

That’s what makes this form of trading risky – by increasing your market exposure through leverage, you amplify your potential profits and losses equally.

An example of leveraged trading

Imagine you wanted to buy 1,000 shares of a company at $1 a share. To open a traditional, unleveraged trade with a stockbroker, you’d be required to pay 1,000 x $1 for an exposure of $1,000 (not including fees).

However, with leverage, you’d pay just a fraction of this cost to gain the equivalent market exposure. In fact, if the margin rate on shares is 20%, you’d pay only $200 to open a position worth $1,000. Your potential profit or loss would be based on the full $1,000.

If you went long on your trade and the company’s share price increased by $0.50, your 1,000 shares would be worth $1.50 each, or $1,500 in total. If you closed your position at this point, you’d make a $500 profit – two and a half times your initial margin amount of $200.

The reverse would be true if you went long and the share price fell by $0.50. You’d incur a $500 loss – again, that’s two and a half times the amount you put down to open the trade. This illustrates the fact that losses can exceed the initial margin amount.

Margin calls

It is the trader’s responsibility to ensure that they have sufficient capital in their account to cover their total margin and any losses they may incur.

At CMC Markets, our maintenance margin level is 50%. This means that if the balance of a trader’s available funds falls to half of the margin requirement for all open leveraged positions on the account, their positions may be closed out. Before that happens, a margin call is triggered at the 80% level. A margin call tells the trader that they need to add more money to their account to keep their trades open, or exit some positions to reduce their total exposure.

To avoid getting a margin call or, worse, hitting the maintenance margin level, it’s a good idea to keep leverage to a reasonable level by managing your position sizes. It’s also sensible to keep your available funds balance well above the margin requirement. For example, if your positions have a total margin of $1,500, having double or triple that amount (or more) in available funds ought to allow for market volatility and reduce your chances of getting a margin call.

What are the risks of using leverage?

As already discussed, trading with leverage brings substantial risks. Here’s a reminder of the key risks and, below, an overview of the steps you can take to mitigate these risks.

• Magnified profits and losses: The primary risk is that trading with leverage amplifies potential profits and losses equally. So, while the possibility of increasing your profits may seem attractive, it’s crucial to remember that leverage can just as easily work against you. Even small adverse movements in the price of an instrument you’re trading can result in significant losses. The magnification of both gains and losses is the core risk of using leverage.
  
  ⚠️ As we saw in our example above, if the market moves against you, you can lose more money than you put into a trade when using leverage. However, our retail clients have negative balance protection, which means their total losses are limited to the amount of funds in their account.

• Margin calls: Another risk of leveraged trading is the potential for margin calls. If the market moves against you, the available equity in your account may drop below our required margin level. You may be asked to deposit more money into your account or close some of your positions. If your available equity falls to 50% of your required margin level, your positions may be liquidated.

• Psychological pressures: Given the above-mentioned risks, the pressures of trading may be too much for some people. If the stress of trading with leverage becomes too great, some traders may start to trade on negative emotions, which can result in poor trading decisions. You should only trade if you’re fully aware of the potential dangers. It’s also advisable to commit no more money than you can afford to lose.

Risk-management tips

The aim of risk management is to minimize potential losses while not surrendering the potential for gains. Although the risks of trading cannot be eliminated, when managed correctly the risks may be kept to a level that you’re comfortable with.

Most traders use a mix of tools and strategies as part of their risk-management plan – a set of rules that guide a trader’s decisions and help them to manage the risks of trading. A solid risk-management plan should consider the following:

• Stop-loss orders: A stop-loss order is an instruction to offload an asset automatically if its price moves against you and reaches an exit point that you’ve set. Stop-loss orders, which you can add to all your trades with us, enable you to limit losses if a trade doesn’t pan out as you’d hoped.

• Position size: Keep leverage to a reasonable level by managing your position size. If you open a large position relative to your account value, even small declines in the instrument’s price could have a significant negative impact on your account and your ability to continue trading.

• Diversification: Don’t put all your eggs in one basket. Spread your risk across multiple assets, sectors and regions to reduce your exposure to market downturns.

You can read more about risk management here.

FAQs

How does leveraged trading work?

Leverage enables you to enlarge your financial position and increase the potential return of a trade. When you trade with leverage, you deposit a fraction of the full value of the trade to open a position, while your broker puts up the rest of the trade’s full value. However, this form of trading amplifies your potential profits and losses equally, making it riskier than traditional investing.

What are CMC Markets’ margin rates?

Our margin rates are established in accordance with the regulations of the Canadian Investment Regulatory Organization (CIRO).

What are the risks of leverage?

When you trade with leverage, you increase your market exposure which means you amplify your potential profits and losses equally. If the market moves against you, you could lose more than your initial outlay. If a margin call is triggered, you may need to add funds to your account or reduce your overall exposure to keep trades open.

What is the relationship between margin and leverage?

When you trade CFDs with us, you deposit the margin – a fraction of the position’s full value – to open a leveraged trade. For example, if you trade on shares, and they have a margin rate of 20% (a leverage ratio of 5:1), you would put up $200 to open a trade with a full notional value of $1,000.