In this article i’m going to answer the question, ‘what is leverage in trading?’. The answer to this question is something you absolutely must become familiar with if you are to become successful as a stock market trader. I will explain to you about the different types of leverage and how you can check the details so that you know exactly what you are dealing with in your broker account.
What is leverage in trading? Let’s start with the basics!
The best way I can describe leverage to you is for you to think about it as a loan for a large portion of a pie. Imagine that the asset you want to purchase, is divided up into pie pieces:
In a broker account with leverage, the broker will ask you to put down, as a deposit, maybe, one slice of pie – this is known as the margin. Why ‘margin’? Think of the margin as a small portion of a page – like the margin on a page. The rest of the pie will be funded by a loan (leverage). What is the point of this? It means when you use a leverage account, you can get into larger position sizes (purchase larger assets) than you would otherwise have been able to afford with your cash in the account.
To fully understand the answer to the question, ‘What is leverage’, you must also understand how much leverage is given by the broker
The amount of leverage (the proportions of the pie funded by a loan vs your own cash), will depend on the type of asset in question, and the broker account. I have set out the typical scenarios below:
Equities
Typically, equities (shares) attract leverage of 4/5 meaning 4 portions of the pie will be funded by the broker as a loan, and 1 portion of the pie will be funded by your cash. (1:5 ratio/20%).
Commodities
Commodities, such as oil, gas, coffee, orange juice etc, will typically attract leverage of 9/10ths of the position size, meaning you put down 10% as your cash deposit, and the broker funds the other 90%.
Indices
On indices you can obtain the most leverage. These instruments can typically allow you to borrow 19/20ths of the asset value with leverage and 1/20th will be funded by your cash.
How can you tell or check what the leverage is, on an asset, before you trade it? If you click on the asset ‘details’ within your broker account, it will say something like 20:1 (for an index) or 5:1 for an equity. Meaning, for every 1 you put in yourself on an equity trade, the broker will fund the other ‘4’.
What are the benefits and drawbacks of using leverage?
The basic benefit is that you can open larger positions so if you are a profitable trader you will make more profit. The downside is that the broker will charge you fees, like interest, for taking the loan in the form of leverage. These are seen in your account as overnight funding adjustments. The broker often charges you if you hold the leveraged positions overnight.
What is leverage in trading: How the leverage is managed in a broker account
On entry into a buy position, the broker will check that you have enough money to cover your deposit (margin). This deposit money will be ring fenced while you are in the trade. The broker typically shows you the amount of margin being used on open positions, and the amount of buying power you have (which is equal to the cash in the account, plus the profit or loss on any open positions, less the margin being used). The rest of the position you purchase will be on a loan.
Important information you MUST KNOW to complete your understanding of ‘what is leverage in trading’
NOTE! – AND THIS IS VERY IMPORTANT! Before you complete your understanding of what is leverage in trading, you must know this. The amount of loss you can take, when trading with a margin/leverage account, can be more than the cash in your account. HOW? I will explain below with an extreme scenario so you get the point.
Imagine you enter a position where the price of the asset is £5,000 for one share, and it’s a share/equity.
ENTRY: £5000 X 2 portions = £10,000 value of trade.
Margin/deposit required: £2,000 – the instrument is an equity so as above, 1/5th of the value of the trade is set aside for margin/deposit.
Cash in account at entry: £2,100.
Price movement: The price goes against you, and each share is now worth £1,000.
Now your open position is worth £2,000. £1,000 x two shares = £2,000.
You have lost on the trade, £10,000 (value at entry) – £2,000 (current value) = £8,000 LOSS.
Your cash level at entry, was only £2,100 – so you have now lost more money than the level of cash you had in the account at the outset.
This is why trading with margin is very dangerous unless you know and fully understand how it works. Don’t worry – this article will help you!
The reality is that you would have got a ‘margin call’, from the broker, asking you to fund the account at the point where you are going into a position where you do not have enough funds to cover the margin. (The broker will deduct/ringfence your loss from the available funds so in the scenario above, the cash in the account was depleted by the loss on the trade). You see, while the position is open, the margin and leverage is moving around, in accordance with the latest share price, compared to your entry point.
If you find it easier to hear and see a video on this, I also published a video on my YouTube channel, here:
I hope you found this article helpful, in understanding the answer to the question, what is leverage in trading. Perhaps if you did, you can leave a comment below?
Disclaimer!
Nothing on this blog should be taken as financial advice or encouragement for you to enter a trade. You are expected to speak to a financial adviser or carry out your own due diligence before entering any positions. Everything on this blog is made for educational purposes and to equip you with the knowledge you need to be able to make your own financial decisions.
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