What is leverage in trading?

In trading, leverage can be an effective tool to allow you to enter larger trades without you needing to provide all the capital upfront.

However, it’s important you thoroughly understand trading leverage before you attempt to use it. Leverage can be risky, and using it means you can lose more capital than you put into your trade.

So, what is trading leverage?

Leverage means you essentially borrow money from a broker and use it to place a larger trade without needing to supply the whole of the capital upfront.

Different trading methods such as CFDs and spread-betting use leverage in different ways.

Why do traders use leverage?

As we’ve seen, a key benefit is that it allows traders to access bigger trades with less upfront capital.

The other key benefit is that leverage can allow you to achieve higher potential returns on your upfront capital than you’re likely to on a non-leveraged trade.

However, before we go through how this works, we need to be very clear: the more leverage you use, the more your losses will be amplified.

You can lose more than your initial capital.

Now we’ve made that clear, let’s go through how leverage works in two key trading methods: CFDs and spread-betting.

Leverage in CFDs.

When you trade Contracts for Difference (otherwise known as CFDs), you’re simply agreeing to exchange the difference between an asset’s value when the contract opens, and the asset’s value when it closes.

The size of your trade is based on how many contracts you choose to open.

How leverage would work in this CFD trade

Your trade size here is $2500. However, you don’t want to put in that whole amount of capital upfront.

So, your broker allows you to use leverage of 1:5.

As we mentioned earlier, you work out your required upfront capital in a leveraged trade by dividing the size of the trade ($2500) by the larger second number in the leverage figure. (5, in this case.)

This means that for this particular CFD trade, you’d need to supply $500 in upfront capital. ($2500 divide by 5 = $500.)

Whatever CFD trade you’re placing, remember that you can work out the required upfront capital by dividing the total size of the trade by the second, larger number in the leverage figure.

Why you need to be very careful when using leverage

When you trade CFDs and use leverage, your profits and losses are calculated based on the size of the trade, not on how much capital you use upfront.

So, let’s say you place a trade worth $20,000, using leverage of 1:20.

This means that you would need $1000 in capital to place the trade. ($20,000 divided by 20.)

Now, let’s say you make 20% return on the trade, giving you a $4,000 profit.

Because you used leverage, though the trade only made 20% (20% of $20,000 is $4,000), because you only actually put $1,000 of capital in, your real return on investment is actually 300%. (300% of $1,000 is $4,000.)

A 300% return on investment is an exceptional result when you don’t use leverage, so you can see why leveraged trades are appealing to some traders.

However, and this is very important, you need to understand that the same principle applies to any losses.

So, if you’d made a 20% loss on this trade, your losses would also have been $4,000. You only put in $1,000 in capital, so you would have lost $3,000 more than you put in.

This is what we mean when we say, ‘you can lose more than your initial capital’.

It’s also why you need to take the use of leverage very seriously, and never trade with money you cannot afford to lose.

Leverage in spread-betting

Leverage in spread-betting is easier to calculate, though you still need to pay attention when using it.

When you spread-bet, your profit and loss is based on points.

If company A’s share price is 25.55, and it rises to 26.00, then your points profit would be 45. (Because the price would have to rise 45 points to hit 26.00.)

When you spread-bet, you speculate how much money you want to bet per point.

So, let’s say that on this trade, you choose to bet £5 per point.

The profit is 45 points. So, your profit would be £225. (45 x £5 = £225.)

The term ‘leverage’ in spread-betting refers to how much you bet per point.

So, £2 per point is relatively low leverage. £10 per point would be high leverage. The more you bet per point, the more both your wins and losses are magnified.

If, for instance, you bet £10 per point and your chosen asset fell 50 points, you would lose £500.

Again, it’s important you take the time to understand this thoroughly, and again, never trade with money you cannot afford to lose.

Summing up leverage

Leverage can be an effective tool if you want to trade the markets with less upfront capital.

However, always ensure you understand the risks that come with using it.

Never trade with money you cannot afford to lose.