Leveraged trading, also refers to as margin trading, enables traders to open larger positions with only a small margin. While traders often boast about their profit multiples, few truly understand the risks associated with leverage.
Leverage is a double-edged sword, amplifying both potential profits and losses proportionally. In this article, we aim to provide a detailed explanation of leverage in trading and the associated risks, helping new traders understand and master leveraged trading.
What is Leverage in Trading
Leveraged trading is familiar to the public, seen in activities like home loans, which are a form of leveraged investment. For instance, buying a $5 million property with a $1 million deposit and a $4 million loan creates a trading leverage of 5x, allowing control of a $5 million asset with a $1 million investment.
In finance trading, leverage empowers investors to open sizable positions with minimal deposits. In the context of property purchase, if the aim is to speculate on housing prices, it essentially mirrors leveraged trading in finance.
Following the property purchase, the profit and loss (PnL) of the investment is calculated based on the entire property value rather than the deposit. For instance, if the property price increases by 10%, the investment’s PnL would amount to $500K (5M * 10%). Conversely, if the property price decreases by 5%, the investment would incur a loss of $250K.
Leverage & Margin Connection
Margin, or margin requirement, essentially is equivalent to the deposit required to initiate a trade. It acts as a threshold for trading, as one must possess at least the deposit amount to enter into a trade.
Leveraged trading often refers to margin trading, as leverage and margin rate are interchangeable concepts. For instance, a 5x leverage equates to a 20% margin rate. Leverage can be articulated in various ways, which may lead to confusion. Below, we compare three different expressions:
Leverage
Leverage is the most straightforward expression, we use 100× leverage to signify leverage of 100 times.
Similarly, 200× leverage indicates a leverage of 200 times.
Leverage ratio
Leverage ratio holds a distinct meaning in trading compared to finance, it’s essentially another term for leverage.
For example, 100× leverage equals to 1:100 leverage ratio.
Margin rate
Margin rate = Margin ÷ Position vavlue × 100%
Although leverage isn’t explicitly stated, margin rate serves as another indicator of leverage. For instance, 100× leverage is synonymous with a 1% margin rate, while a 0.5% margin rate represents a leverage ratio of 1:200.
Leverage & Margin Calculation
1). Leverage Calculation
In the property market, leverage depends on how much we can borrow from the bank and how much deposit we can afford. However, in online trading, leverage is determined by the exchange or broker.
There isn’t a formula for calculating leverage in online trading because it varies among brokers, markets, and instruments. For instance, leverage ratios in futures markets typically range from 1:10 to 1:20, while in margin forex trading, leverage can exceed 100×.
2). Margin Calculation
The margin calculation varies across different markets. In markets like futures trading, the margin requirement is set by the exchange and may fluctuate over time based on market volatility. However, in certain other derivatives trading, leverage is a fixed trading condition and can be calculated using the formula below:
Margin requirement = Value of position ÷ leverage
The formula applies to stock, margin forex, and CFD trading. In fact, traders don’t need to manually perform the calculations themselves, the margin information is readily available on the trading platform at the instrument level.
The Function of Leverage
The content in the previous chapters has already covered the function of leverage, however, we will revisit it in this dedicated section. This is because many people, especially new traders, often misinterpret leverage, believing that it can increase their account capital.
For example, let’s say we have $200 capital, and 100x leverage can supposedly increase it by 100 times to $20,000. This is a very common misunderstanding. Leverage does not augment the account capital, instead, it amplifies the position size that traders can control.
Let’s illustrate this with an example of gold trading. Suppose we have $200 in capital and want to buy 1 ounce of gold with 100x leverage, when the gold is trading at $2000 per ounce.
The value of 1 ounce of gold is $2000, but we only have $200 in capital. How can we make the trading happen? It will be easier to understand if we convert the 100x leverage to a 1% margin. With a 1% margin ($20), we can open a position valued 100 times higher ($2000).
Risk of Leveraged Trading
Leverage is a double-edged sword, amplifying both potential profits and potential losses proportionally. In comparison to traditional finance trading, leveraged trading presents three additional risks:
1). Risk of losing rapidly
Let’s compare two examples of gold trading: one without leverage and another with a leverage ratio of 1:100. In both examples, we have a capital of $200.
Gold trading without leverage
Buy 0.1 ounces when gold is traded at 2000 per ournce
The PnL would be $20 for a 10% price fluctuation.
Gold trading with 100× leverage
Buy 1 oz with a margin of $20 when gold is traded at 2000
The PnL would be $200 for a 10% price fluctuation.
With a capital of $200, the maximum amount of gold we can purchase without leverage is 0.1 ounces. Consequently, the profit and loss (PnL) will be based on the movement of 0.1 ounces.
In contrast, with a leverage ratio of 1:100, we can buy 1 ounce of gold with a small margin of $20. The resulting PnL will be for the entire 1 ounce. With the same 10% price fluctuation, the PnL for 0.1 ounce is just $20, while it rises to $200 for 1 ounce.
In the leveraged trading example, we could incur losses rapidly if the market moves against us. In some cases, we might lose all of our capital in just a few minutes or even a few seconds.
2). Risk of Over-leveraged
Being over-leveraged doesn’t necessarily mean a trader is using an extremely high leverage ratio, it rather indicates that the position opened is too large in comparison to the account capital. Even a small price fluctuation could result in significant losses and potential liquidation.
Let’s illustrate this with two gold trading examples again, assuming the account capital is $200 and the leverage is 100x:
Buy 1 ounce gold
Only requires $20 margin when gold is traded at 2000.
After opening the position, the free margin available to absorb floating PnL is $180
The recent daily gold price fluctuation is about $30, a free margin of $180 is sufficient to maintain the position safely for a week.
Buy 8 ounces gold
The margin is $160 when gold is traded at 2000/ounce.
The free margin available to absort floating PnL is only $40 after the position is opened.
A free margin of $40 can only accommodate a price movement of $5, which could occur in a minute or even a second on gold.
With the same $200 account capital, a position size of 1 ounce can survive for a week, indicating it is not over-leveraged. However, when the position size increases to 8 ounces, even a slight price fluctuation within a minute or even a second can lead to forced liquidation. Therefore, this is absolutely over-leveraged.
Although there is no universal standard, but a common measure of over-leveraging is how long the position can sustain or how much unfavorable price fluctuation the account can withstand.
Over-leverage falls into the category of trading psychology. Many traders tend to open additional positions when facing losses in the hope of quickly recovering their losses, which can ultimately result in even larger losses.
3). Risk of Margin call
Margin call is a risk inherent in all leveraged trading. While the specific rules may vary, the underlying logic remains consistent. When a trader’s account equity falls below a certain level due to running losses, the broker will initiate forced liquidation of the open position, thereby preventing the trader from losing more than the account capital.
In high leveraged trading, such as margin forex trading and CFDs trading, forced liquidation is a common occurrence for many traders. To learn more about margin calls, please read our other article titled「How to Lower Margin Call Risk? Understanding Forex Margin Call」.
High Leverage vs Low Leverage
Ther is no definitive answer for the debate between high leverage and low leverage in trading. Low leverage is commonly perceived as less risky due to reduced margin call risk, but it also implies a higher trading threshold.
However, the primary determinant of trading risk is not leverage, but rather position size. The larger the position size, the higher the trading risk. Surprisingly, with the same account capital and position size, higher leverage can help traders withstand more market volatility, offering a better chance of closing with profit.
To illustrate this point, let’s consider two gold trading examples. In both cases, we have a $500 account capital and open a long position of 10 ounces of gold at $2000 per ounce, assuming the margin call will be triggered when the account equity drops to the same level as the margin. One example uses a 1:100 leverage ratio, while the other uses a 1:200 ratio. The table below compares the key factors for these two examples:
| 100× leverage | 200× leverage | |
|---|---|---|
| Margin | $200 | $100 |
| Free margin | $300 | $400 |
| Margin call price | $1970 | $1960 |
In the example of 100x leverage, the remaining free margin after opening the position can absorb a $30 price decline, indicating that the position will reach margin call when the gold price drops to $1970. However, in the case of 200x leverage, the available free margin will be $10 higher than that of the 100x leverage example, delaying the margin call trigger until the gold price falls to $1960. From this perspective, higher leverage appears more favorable to traders.
However, human nature often leads many traders to become emotional and unable to control themselves, resulting in the opening of larger positions with high leverage. As the position size increases, so does the trading risk.
There are several factors influencing leverage, including capital amount, trading goals, trading strategy, risk preference, and even the characteristics of the traded instrument. For new traders, the typical leverages such as 200x and 500x provided by high leverage brokers are generally sufficient.
High Leveraged Trading Markets
1). Futures Trading
The futures market is the most common form of high leverage trading, with typical leverage ranging from 10x to 20x. Originally, the futures market was established to provide a hedging tool to participants in the underlying market. Consequently, despite the involvement of many individual traders in futures trading, the market remains largely dominated by institutions.
The trading thresholds, which encompass contract size and margin requirements, are often too high for many individual traders, as they are primarily designed to accommodate institutional investors.
2). Leveraged Forex Trading
3). CFD Trading
CFD, or Contract for Difference, is a derivative financial instrument that can be based on any financial asset. For instance, there are Brent CFD, Dow Jones CFD, and even margin Forex trading alls under the category of CFD trading.
With CFDs, investors are not required to hold positions in the underlying market, instead, they can speculate on the price fluctuations of the underlying asset directly with high leverage.
Click and read「What is CFD Trading? Trade the Global Market with CFD」 to learn more about CFD trading.
