What Is Leverage In Trading?

A tool for magnifing your potential profits and losses.

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Last updated: February 22nd, 2024

what is leverage in trading

The information on this page is general factual information, not financial or investment advice. Before acting on this information, consider its appropriateness in regard to your financial situation, objectives and needs. All trading involves risk. Only risk capital you’re prepared to lose. Read the financial advice disclaimer.


Last updated: February 22nd, 2024

Reading Time: 8 minutes

Leverage trading is a powerful tool that allows you to control more substantial positions in the market than your available capital would allow otherwise. Often called a double-edged sword, leverage in trading is capable of both amplifying potential gains and increasing potential losses.

Let’s unpack the meaning of the term “leverage” in the context of trading on financial markets.

We will discuss using leverage to amplify your buying power, reveal (substantial) risks involved, show you examples of leverage trading, and talk about limits to how much leverage you can use.

(Related: How To Spot Forex Trading Scams).

What Is Leverage?

You’ll often see an option to apply leverage if you trade CFDs, forex or common stocks using online brokerages and trading apps.

Leverage is using a small amount of money to gain access to a larger sum — borrowed from the broker — which magnifies your risks and potential returns.

what is leverage

You incur losses (or make profits) based on the size of your inflated position, rather than the funds in your account.

  • Leveraged trades are commonly taken out when purchasing derivative financial instruments (e.g., futures and options).

That is, rather than investing to own the underlying asset, you speculate on the change in the price of that asset.

Important!

The speculative and volatile risk-reward nature of leveraged trading — and brokers’ history of promoting the practice to unsophisticated investors — has seen them described as “financial heroin hits” by the Australian Securities And Investments Commission (ASIC).

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How Much Funds Can You Access With Leveraged Trading?

The amount that you can leverage will depend on a range of factors, including:

  • Amount of money in our account (you need sufficient funds to cover the initial margin)
  • Size of the position you want to open.
  • Your credit history.
  • Margin requirement (more about this shortly).
  • Market and asset you want to trade (riskier assets attract lower leverage ratios).
  • Regulatory environment your broker operates in (ASIC-regulated brokers are all capped at 30:1 leverage).
Leverage trading is similar to margin trading in that you borrow from the broker to fund your trade.

But when buying stock on margin, you can only borrow against the value of your existing collateral (the value of shares you already own).

What Is Leverage Ratio?

Most brokerages and exchanges represent the amount of leverage you can obtain using a leverage ratio formula that looks like this:

  • 5:1
  • 10:1
  • 30:1

For example, using 10:1 leverage you can control up to $10,000 using only $1,000 in your trading account.

In other words, for every $1 in your account, you can place a trade that’s 10X greater, borrowing the delta from your broker.

Important!

Leverage is sometimes represented with an “X”. For example, 5X, 10X and 20X. The format has the same meaning as 5:1, 10:1 and 20:1, and is more commonly seen in crypto markets.

What Is Margin?

Margin is the amount of funds you need to provide based on your chosen leverage ratio. 

For example, if you want to buy $10,000 of Rio Tinto at 10:1 leverage, you need to deposit $1,000 of your own cold hard cash, while your broker will supply the remaining $9,000.

  • The $1,000 deposit is your margin.

Keeping a leveraged position open required maintaining a sufficient margin.

Important!

If you experience losses that threaten to exceed your initial margin amount, you’ll be prompted to top up your account to keep trading — known as a margin call.

What Are Examples Of Leverage In Everyday Life?

You may not be aware of this, but you’re probably already using leverage because it simply refers to investing in underlying assets with borrowed money.

Example 1: Your Home Loan.

Not many people have enough cash to buy a house or investment property outright, so they use leverage.

For example, let’s say you put down a deposit of 20% to buy a $5 million home.

You control a $5m asset using $1m of your money and take on the risks and downsides — such as changes in property values, paying interest, and managing insurance and maintenance.

Example 2: Your Car Loan.

Few people buy expensive cars (aka depreciating assets) with cash. Usually, a 10% deposit is enough to put one in your driveway.

Fancy a new Range Rover Sport for $200K? Give $20K to the dealer, and it will magically appear in your driveway.

Example 3: Your Share Portfolio.

You want to buy Tesla stock because you think Elon’s leadership will result in 15% growth, but only have $5,000 in spare cash.

No problem.

You can borrow $50,000 from your bank at 5% to buy the Tesla stock. If your instincts about Elon and his company are right, you’ll net a 10% return (more about this shortly).

What Are Some Examples Of Leverage In Trading?

Day traders and investors have effortless and streamlined access to leverage through online brokerages, trading platforms, mobile investing apps and dedicated CFD trading platforms.

No clunky loan applications are needed. You select the leverage ratio that aligns with your appetite for risk and the goals of your trading strategy.

Example 1: Forex Markets.

International forex trading platforms typically offer larger leverage ratios because the value of currencies doesn’t fluctuate greatly daily. Australian forex platforms, however, are throttled back to 30:1 by ASIC.

  • Let’s say you want to open a position of $50,000 for a USD/AUD pair, at ASIC-mandated 30:1 maximum leverage.
  • You would need to tie up only $1,667 of your own funds.

(Related: Forex Trading In Australia: Risks And Rewards).

Example 2: Stock Markets.

Back to Elon, let’s say you want to buy $50,000 of Tesla stock at a more sensible, but still very high 20:1 leverage.

  • You end up controlling a $50,000 position by depositing $2,500 of your own funds.

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What Is The Benefit Of Using Leverage In Trading?

You can magnify your profits by taking out a larger position, without having to put up the trading capital yourself.

You maximise the impact of your money to potentially improve your upside, but accept increased risk.

Following our example of buying Tesla stock, you’ll make $7.5K gross profit, pay $2.5K in interest and net $5K in the first year – if your predictions about the company are correct.

Conversely, a direct investment in shares using your $5,000 of available cash on hand, would have resulted in a net return of $750.

(Related: What Is Slippage In Trading?)

What Is The Downside Of Leveraged Trading?

You can face much larger losses – because there’s no such thing as free money.

You can lose significantly more, and much faster, when making leveraged trades compared to traditional investing approaches.

Let’s say Tesla shares drop by 15% because Elon gets cancelled for tweeting something silly (as he has been known to do). Based on the leveraged position we described earlier:

  • Your portfolio is now worth $42.5, and you’re still paying 5% on the $50K you borrowed.
  • You lost $2.5K in interest, plus $7.5K in assets = $10,000.

Whereas, if you simply invested your own $5,000 without using any leverage, you would have been only $750 down, with a net position of $4,250.

High leverage ratios make it more likely that you’ll lose all of your funds as a result of small price movements against your position.

You’ll also pay interest on your borrowed capital, which depletes your funds and eats into potential profits.

Have a look at this table to see how high leverage affects your trading account.

Leverage% Change In Asset Price% Change In Account
100:11%100%
50:11%50%
30:11%30%
10:11%10%
5:11%5%
3:11%3%

What this shows is that when using leverage ratio of 100:1, a movement of 1% in the price of the asset will create a 100% change in your trading account. 

Yes, if the price change is in your favour, you’ll double our money. But if it’s not, you’ll get wiped out entirely. 

Tightening Of Regulations Around Leveraged Trading.

ASIC conducted a major regulatory overhaul of the Australian forex and CFD market in 2020, after their investigations revealed major losses from leveraged trades by retail investors.

  • ASIC was spurred into action after discovering most retail clients experience significant losses when trading CFDs.

In fact, beginner investors lost more than $774 million in one five-week period during 2020, which also resulted in over 15,000 accounts going into negative balance, owing $10.9 million.

The regulator issued a product intervention order in March 2021 that placed limits on maximum leverage ratios, and required brokers to help protect traders against going into negative balance.

Leverage trading ratio that brokers can offer has been limited to:

  • 30:1 for FX majors.
  • 5:1 for shares.
  • 2:1 for crypto.

Designed to help Australian investors make more sober decisions and minimise broker tactics to encourage risky trades, the restrictions will stay in place until their next review, in May 2027.

The changes have reduced worst-case scenarios associated with the overuse of leverage by novice investors.

Important!

Within six months, ASIC found a 91% reduction in combined net losses by retail accounts trading CFDs.

How To Minimise Risk When Using Leverage.

Australians engaging in leveraged trading can take the following risk-mitigating steps:

  • Use stop losses: A stop loss lets you determine the when the broker should automatically close a position. The level you set is known as the stop price.
  • Improve your sophistication: Trade in line with an investment strategy or business plan that helps you gauge when trading in certain markets is a good or bad idea. Stay abreast of news and market volatility, so you can avoid trading at inopportune times.
  • Negative balance protection: ASIC-registered brokers are required to offer negative balance protection, which ensures that traders cannot lose more than their account balance, even if their positions move significantly against them.
  • Diversify your portfolio: Diversification can spread risk across different assets, reducing the impact of losses on any single position. Also consider multiple trades with a position size that doesn’t affect your overall capital, rather than placing fewer large trades.

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Frequently Asked Questions About Leveraged Trading.

While leverage trading is quite a simple concept, it tends to have complicated consequences.

What Is A Margin Call?

Dreaded by investors or all levels. A margin call is a warning provided by your broker or financial institution, to let you know that your losses are threatening to deplete your initial margin (or have already done so). 

In this case, you must deposit more money into your account to keep your trading positions open.

Failure to add more funds after a margin call will result in the automatic closure of your open trading positions and total loss of capital.

However, topping up your accounts after a margin call comes with the risk that you’ll lose even more. Knowing when to close a position and cut your losses is part of becoming a wiser trader.

What About Trading Multiple Positions?

Trading multiple positions is a common practice in leverage trading and involves opening various trades simultaneously. Reasons traders might chose to open multiple positions include:

  • Protection: You can spread your risk across multiple trades or cover both directions of price movement as a potential risk management strategy.
  • Higher rewards: Stacking trades in the same asset at different price levels can boost overall profits as the market trends in the right direction. It’s risky, and to be effective you’ll need to set stop-loss orders and take profits as trades pan out.

What Investments Can Be Leveraged?

You can apply leverage to a number of asset classes. This will vary from broker to broker, but as a rule of thumb, Australian investors have access to leveraged trading on:

  • Forex currency pairs (e.g., GPB/USD, AUD/USD).
  • Commodities (e.g., gold, silver, oil, and natural gas).
  • Stocks, indices and ETFs from global exchanges (e.g., NYSE, ASX200, NASDAQ).
  • Cryptocurrencies (e.g., Bitcoin, Ethereum, and Cardano).

What Is The Maximum Amount Of Leverage I Can Get In Australia?

While ASIC-regulated brokers can offer retail forex traders a maximum of 30:1 leverage for major currency pairs. That means for every $1,000 you invest, you can make forex trades worth $30,000.

Other leverage limits include:

20:1Minor currency pairs, gold or a major stock market index.
10:1Commodities (other than gold) or minor stock Markey index.
2:1Cryptocurrencies.
5:1Shares and other assets.

Internationally registered brokers can offer greater leverage ratios to Australian clients, up to 500:1 or even 1000:1.

Important!

You need to weigh the risks of trading with a broker not covered by Australian regulations. These are designed to protect retail investors from manipulative and fraudulent practices. It may be difficult to resolve any issues or disputes if they arise as unregulated brokers are not subject to same levels of scrutiny by the regulator if they act outside the law.

Why Is Leverage Trading Called A Double-Edged Sword?

Leverage can have both positive and negative consequences, in equal measure. That’s because both your profit and loss are calculated on the full size of your position – not the margin amount that you put in.

  • If the market moves in your favour, you’ll see magnified profit based on your full position size.
  • If the market moves against your position, you’ll suffer a magnified loss, calculated on your full position. 

Is Leverage Trading Recommended For Beginners?

The higher the leverage, the higher the chances of your account being wiped out – especially if you’re trading without a stop loss.

This is why beginners should dabble in leveraged trading with a lot of conservativism and caution.

Final Words About Leveraged Trading.

So, what is leverage in investing?

Leveraged trading cuts both ways. It magnifies your exposure and your potential losses, but used sensibly, can be a potent tool for potentially delivering more profit.

Steven

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0 thoughts on “Plus500 Review Australia: Pros, Cons, Fees & Verdict

  • I attempted to use the “hack” to dodge conversion fees, but sadly after converting AUD to USD on a Wise account, there doesn’t seem to be a way to deposit that money into eToro; i.e. eToro recently disabled Wire transfers and Wise doesn’t support SWIFT transfers for sending USD to a bank in the US?

  • John Keys says:

    CMC Invest are an abysmal in turning around new accounts.
    Over 1 month to setup up an account with an investment trust, and still waiting. I was promised 5 business days.

  • Reg Watson says:

    Given that China’s economy is going down the toilet how the heck do we expect an appreciation of the Aussie in 2024 ? We are tied to China.

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