Leverage in trading

So, what does leverage mean? Leverage is the ratio applied to the margin amount to establish how big a trade is going to be placed. Understanding margin and leverage and the difference between the two can sometimes cause confusion. It is important to realise that margin is the amount of capital that is required to open a trade.

Leveraged trading is more likely to be adopted by those trading short-term price movements. It would be much less suitable to anyone investing long-term, for example over multiple years or even decades. In this instance, a ‘buy and hold’ approach would be more suitable. In this instance, a ‘buy and hold’ approach would be more suitable. It is important for all traders to bear in mind the risks involved in leveraged trading. Many traders see their margin wiped out incredibly quickly because of a leverage that is too high. Novice traders should be especially careful when practising margin trading. It is best to be more prudent and use a lower leverage. A lower leverage means traders are less likely to wipe out all of their capital if they make mistakes.

To start trading on leverage, it is advisable that a trader starts with a leverage that is lower than their maximum leverage allowance. This enables traders to keep their positions open for the full size, even if they are experiencing negative returns.

For example, let’s say a trader has a maximum leverage of 10:1 and opens a position with that leverage on a $10,000 account. The trader now has a position size with an asset value of $100,000. This means a price movement of 1% will wipe out the position completely. Also consider that if the position is losing $5,000, the broker may reduce the trader’s position. This is because the trader now only has $5,000 of available capital, and 10:1 leverage means his maximum position allowed should be $50,000 not $100,000.

Reducing the leverage to 5:1 with an initial outlay of $10,000 will mean that the position is now $50,000, and a 1% move will be equal to $500. Keeping leverage rates low means that if the trader does lose money, it is less likely to wipe out all or a substantial amount of their capital.

Open a demo account to practise trading with leverage on our advanced trading platform.

Leveraged products are derivative instruments that are worth more on the market than the deposit that was initially placed by an investor. The two significant leveraged products that we offer are spread betting and contracts for difference (CFDs). When trading with leverage on either of these products, an investor can place a bet using a reasonably small margin on which way their chosen market will move. The investor technically does not own the underlying asset, but their profits or losses will correlate with the performance of the market.

The key difference between spread betting and CFD trading is that the former is exempt from capital gains tax (CGT), while the latter requires you to pay this tax. CFD traders will also have to pay a commission charge in addition to the spread when trading shares. To calculate your profits or losses, you must find the difference between the price at which you entered and the price at which you exited. For spread betting, this figure should then be multiplied by the stake, and for CFDs, it should be multiplied by the number of CFD units. Both are at risk of financial loss, but equally, financial gain if the market moves in a favourable direction. Spread betting is only available to customers residing in the UK or Ireland, whereas CFDs can be used globally. Read more about our CFD commission rates here, along with our article on CFD meaning.

An important aspect in using leverage is understanding how to calculate the ratio. The following leverage ratio formula is commonly used and easy to remember:

L = A / E

where L is leverage, E is the margin amount (equity) and A is the asset amount.

Therefore, dividing the asset amount by the margin amount gives the ratio of leverage.

It is also possible to start with the margin amount and apply a leverage ratio to determine the position size. In this instance, the formula would be A = E.L. Therefore, multiplying the margin amount by the leverage ratio will give the asset size of a trader’s position.

Most traders distribute risks across different markets, meaning they are not putting all their capital into one trade. This is done by opening various positions in different markets. When this is the case, there may be the need to do calculations to determine net asset value or the accumulative value of a trader’s positions. Thanks to platform technology that most brokers will offer, it is easier to monitor all parameters and open or close individual positions as needed. More importantly, it can help a trader work out if positions fit within their total leverage amounts, which should be less than the maximum leverage allowed by the broker.

As discussed, we have differing leverage ratios and margin rates for each type of financial market and asset. All products are available on our award-winning trading platform, Next Generation, where you can put into place risk management tools, such as stop-loss and take profit orders. Familiarise yourself with our platform now by creating a live account, or practise first with virtual funds on a demo account, which is included for free upon registering. Take a look at our extensive list of charting features here.

Spread betting is the most popular product on our platform, which you can use to trade an endless array of financial assets. As discussed, you must use leverage when spread betting our products, which can bring risks. This is why we offer you the chance to familiarise yourself with the platform on our demo account before depositing real funds. Below, we explore the risks of spread betting leverage in more detail.

The most important thing to understand when talking about leverage is the risk involved. Risk is inherent to any type of trading, however, leverage can cause both magnified profits and losses. It would be prudent for traders to pay particular attention to choosing how much leverage they will use. The leverage ratio should be determined in advance of trading. It is very tempting to trade in a larger size than what was originally determined if you have a streak of winning trades.

Doubling your risk on a one-off basis could benefit a trader if they happen to get that one-off trade right. But get it wrong and a trader could end up facing a much larger loss than usual. To help reduce risks in trading, you should plan out your trading strategy in advance.

Two factors could be taken into consideration when determining what amount of leverage to apply to a portfolio: how much risk to take per trade and how much risk to take per day. Examining this via percentages makes things easier. First, a trader can determine how much risk they are willing to take per day. This involves deciding the maximum amount that you are willing to lose. This could, for instance, be between 1% and 2%. If a trader were using 2% as maximum daily risk, it would take 50 days of bad losing trades in a row to wipe out their capital, which is hopefully extremely unlikely to happen.

A trader should also determine how many trades they want to place per day. This could be a set number or a maximum number. For example, a trader may decide that whatever the market, they will make a maximum of three trades a day. In each case, the trader can divide the percentage they are willing to risk per day by this number.​

A popular risk-management tool to be considered when trading with leverage is a stop loss. By implementing a stop loss order to your position, you can limit your losses if your chosen market moves in an unfavourable direction. For example, a trader may choose a pre-determined figure that they do not want to surpass, meaning that your stake in the instrument will be sold at the given price. However, please note that basic stop losses are susceptible to market gapping and slippage. Guaranteed stop losses work exactly in the same way as basic stop orders, although investors can choose to pay a small fee to guarantee the closing of a trade at the exact price specified. This way, if you have used a particularly high leverage in the trade, there will be less chance of multiplying your losses, regardless of market volatility.

Read more about how to protect your money in trading with our risk management guide.