How Does Leverage Trading Work?
Leverage trading, in the most basic sense, is any type of trading that involves borrowing money or otherwise increasing the number of shares involved in a trade beyond the number of shares you could afford when paying in cash.
It’s not a bad thing to trade on leverage if you know what you’re doing and understand the risks. But if that’s not the case, it’s extremely risky and you could potentially lose a lot more than you can afford to.
Here are the different ways you can use leverage to trade in stocks:
Trading on Margin
A simple example is trading on margin. Margin is money you borrow from your broker to buy a security, using other securities in your brokerage account as collateral.
Note
Federal regulations set the minimum margin requirement at 50%, meaning you can borrow up to 50% of the price of a security you want to buy. Some brokers may have higher requirements.
For example, you have $10,000 in your brokerage account and want to invest in Company XYZ. XYZ is currently trading at $50 per share.
If you purchased shares with just the cash you have, you could afford 200 shares. If you decide to use margin, borrowing $10,000 from your broker, you could buy 400 shares instead. This amplifies your potential gains and losses.
If the share price rises to $60, you’d earn a profit of $2,000 or 20% if you invested with cash. If you used margin, you’d earn $4,000 or 40% of the cash you invested.
However, if the price dropped to $40, you’d lose $2,000 with a cash investment and $4,000 if you invested using margin. Remember: You have to pay back the money you borrow from your brokerage.
You’d lose all of the money you invested if you used margin and the stock price of XYZ fell to $25. You’d owe money to the broker even after selling your shares if the price fell below $25.
Note
Many brokers also charge interest on margin loans, increasing the cost of investing with leverage.
Trading Derivatives
Options are another method of trading with leverage. One options contract typically involves 100 shares of the underlying security. Buying an options contract lets you gain control over 100 shares for far less than the cost of buying 100 shares of a company. This means that small changes in the price of the underlying security may cause large changes in the value of the option.
Imagine you think that XYZ is going to lose value instead of gain value. Instead of buying shares using margin, you might decide to sell call options on the stock, setting a strike price of $40. Call options give the option holder the right, but not the obligation, to buy shares from the option seller at the set price.
If the price of XYZ remains above $40, the option holder will likely exercise the option, forcing you to buy shares on the open market to sell those shares to them for $40 each. One contract covers 100 shares, which means that if XYZ Is trading at $41 when the option is exercised, you’ll lose $100. If it’s at $50, you’ll lose $1,000.
Leveraged ETFs
There are also ETFs that use leverage to try to affect how they perform compared to the market.
Note
ETFs typically track a particular index; leveraged ETFs aim to track the gains or losses of the index they are benchmarked to. For example, a 3x S&P 500 ETF such as the Direxion Daily S&P 500 Bull (SPXL) aims to return 3x or 300% the returns of the S&P 500 on a daily basis.
There are also inverse ETFs that aim to deliver the opposite performance to the performance of the benchmark index. A 3x inverse ETF aims to triple the opposite performance of the underlying index. So if the underlying index is negative, the 3x inverse ETF such as ProShares UltraShort (QQQ) ETF would return a positive 3x return.
The Risks With Leverage Trading
One of the primary risks of leverage trading is the fact that it amplifies your potential losses, potentially to the point where you can lose more money than you have available.
Margin Risks and Margin Call
For example, if you use margin to double your purchasing power, you double all of your gains and losses. That means that if a stock you buy loses more than 50% of its value, you’ll lose more than 100% of the cash you had available to invest.
Another risk is that your brokerage could initiate a margin call. If your account’s value falls below a set threshold compared to the money you’ve borrowed, your broker may demand you deposit additional funds. This can happen because your broker worries about your ability to repay your debt if your investments continue to lose value.
Note
If you fail to deposit sufficient funds to meet a margin call, your broker may forcibly sell some of your securities to pay itself back, sometimes without notification. Your broker also decides which securities to sell and has the right to increase margin requirements at any time.
Potential for Unlimited Loss With Options
Some leverage trading strategies, particularly options, have potentially infinite risk.
If you sell a call option and the option seller exercises it, you need to buy 100 shares of the stock to sell to the person who holds the call. If the strike price is $50 and the market value for the stock is $60, you’ll lose $1,000. If the market value is $70, you’ll lose $2,000. If the market value of a share is $1,000, you’ll lose $95,000.
The higher the market value of the share rises, the greater your losses will be. Because there theoretically is no limit to how high a share’s price can rise, there is no limit to how much money you can lose. Imagine each share wound up trading for $1 million or $10 million. You’d lose hundreds of millions or billions of dollars.
While this scenario isn’t likely, because there’s no limit to how high a stock can rise, it’s important to understand that the risk of these kinds of options can be immense.
Leveraged ETFs Not for the Long Haul
Even buying shares in leveraged ETFs has risks. Most funds “reset” daily, meaning they only aim to match the one-day performance of their index. Over the long run, their returns can significantly diverge from the overall returns of the benchmark.
For example, according to the SEC, between December 1, 2008, and April 30, 2009, an index rose 8%. Meanwhile, a 3x leveraged ETF tracking the index fell 53%, while a 3x inverse ETF tracking the index declined by 90%.
Key Takeaways
- Trading with leverage involves borrowing money to invest in the stock market
- Leverage increases your risk for loss, to potentially unlimited loss from bad investments
- Your broker may sell investments on your behalf if their values drop below a set amount
Frequently Asked Questions (FAQs)
Is leverage trading dangerous?
Leverage trading can be dangerous because it amplifies your potential investment losses. In some cases, it’s even possible to lose more money than you have available to invest.
Is leverage trading good?
Leverage trading can be good because it lets investors with less cash increase their buying power, which can increase their returns from successful investments.
Do you have to pay back leverage?
Yes. If you borrow money to invest, such as by trading on margin, you will have to pay it back to your broker. Many brokers also charge interest on margin loans, increasing the cost of investing with leverage.
FAQs
The best leverage in forex markets depends on the investor. For conservative investors, or new ones, a low leverage ratio of 5:1/10:1 may be good. For seasoned investors, who are more risk-friendly, leverages may be as high as 50:1 or even 100:1 plus.
How do you explain leverage in trading? ›
What does leverage mean in trading? Leverage in trading enables you to open a position worth much more than the money you deposit. For example, you might be able to multiply your position size by 5, 10, 20 or even 33x the amount of your initial outlay.
What is 5x or 10x leverage? ›
5x leverage: $100 × 5 = $500. Thus, we can buy $500 worth of stock with only $100. 10x leverage: $100 × 10 = $1,000. Thus, we can buy $1,000 worth of stock with only $100.
What is $100 dollars with 20x leverage? ›
For example, opening a trade with $100 and 20x leverage will equate to a $2000 investment. Is leverage good in the stock market? Leverage trading can be good because it lets investors with less cash increase their buying power, which can increase their returns from successful investments.
Is 1 10 leverage enough? ›
If you are conservative and don't like taking many risks, or if you're still learning how to trade currencies, a lower level of leverage like 5:1 or 10:1 might be more appropriate. Trailing or limit stops provide investors with a reliable way to reduce their losses when a trade goes in the wrong direction.
What leverage is good for $100? ›
Many professional traders say that the best leverage for $100 is 1:100. This means that your broker will offer $100 for every $100, meaning you can trade up to $100,000. However, this does not mean that with a 1:100 leverage ratio, you will not be exposed to risk.
What is the best leverage for $20? ›
Traders with a $20 account should use a maximum leverage of 1:50 and should only use it when they have a good understanding of the risks involved. They should also consider the size of their trades, use a stop-loss order, and focus on building their trading skills and experience.
What leverage is good for $50? ›
The best leverage for $50 is 1:100 for traders outside of the EU. If you are not a resident of the EU then the leverage restrictions are very relaxed. They can go as high as 1:3000 leverage in some financial jurisdictions. The best leverage a $50 account can open in forex will depend on the broker you choose.
How leverage works for dummies? ›
Leverage is the use of debt (borrowed capital) in order to undertake an investment or project. The result is to multiply the potential returns from a project. At the same time, leverage will also multiply the potential downside risk in case the investment does not pan out.
What leverage is good for $10000? ›
Therefore, with a $10,000 account and a 3% maximum risk per trade, you should leverage only up to 30 mini lots even though you may have the ability to trade more.
A financial leverage ratio of less than 1 is usually considered good by industry standards. A leverage ratio higher than 1 can cause a company to be considered a risky investment by lenders and potential investors, while a financial leverage ratio higher than 2 is cause for concern.
Is 3x leverage risky? ›
However, 3x exchange-traded funds (ETFs) are especially risky because they utilize more leverage in an attempt to achieve higher returns. Leveraged ETFs may be useful for short-term trading purposes, but they have significant risks in the long run.
How much is $50 with 100x leverage? ›
Now you are in the market with $50 x 100 = $5000 worth of contracts. It is attractive because if the price of BTC goes up, Your profit has also increased ten times.
What is the best leverage for $300? ›
$300 is the minimum amount of money required in a mini lot account, and the best leverage on this account is 1:200. This would mean you will have $60,000 to trade with. Other leverage you can use in forex trading include; 1:50.
What is the best lot size for $100? ›
The best leverage for $100 forex account is 1:100.
You can now invest $10,000 and before trading, you need to manage your risks properly so that you do not blow your account. Your lot size should not be more than 0.01 and do not risk more than 2% per trade.
Does 10x leverage mean 10x profit? ›
A 10% favorable price move times 10x leverage equals a 100% profit on the trade. However, if they bet wrong and the price goes to $55,000, they would incur a $1,000 loss which would wipe out the entire balance of their collateral, despite the price of the asset only moving 10% against them.
Is 1 50 leverage risky? ›
The main risk of using 1:50 leverage is, of course, associated with the possibility to lose a lot of money. In fact, it is possible to lose more than you have deposited in your account when using excessive leverage without any stop losses or other tools for fund protection.
What is the best leverage for a $2000 account? ›
In general, it is recommended to use a leverage value between 1:50 to 1:200 when opening a forex account with $2000. This range provides a reasonable balance between risk and reward, allowing you to control a significant position in the market while minimizing your losses.
What is the best leverage for $1000? ›
50:1 leverage (2% margin) is a good way to go. But your risk management doesn't stop there. After you accept trading with the constraint of 50:1, you should only risk 1% to 2% of your account with any given trade.
Is 1 1000 leverage risky? ›
Brokers with Leverage 1:1000
For example if the broker gives 1% margin, you will have to deposit 100$. However, this kind of trading is extremely risky and it is not recommended.
When determining what leverage to use, traders should take several important things into consideration. First of all, they should keep in mind that 1:500 or 500:1 is an extremely high level of leverage in trading and it is not allowed in many jurisdictions due to the high risk for losing one's capital.
What is the 2% rule with leverage? ›
One popular method is the 2% Rule, which means you never put more than 2% of your account equity at risk (Table 1). For example, if you are trading a $50,000 account, and you choose a risk management stop loss of 2%, you could risk up to $1,000 on any given trade.
What leverage do professional traders use? ›
Many professionals will use leverage amounts like 10:1 or 20:1. It's possible to trade with that type of leverage, regardless of what the broker offers you. You have to deposit more money and make fewer trades.
Can you lose more than 100 with leverage? ›
The downside to using margin is that if the stock price decreases, substantial losses can mount quickly. For example, let's say the stock you bought for $50 falls to $15. If you fully paid for the stock, you would lose 70% of your money. However, if you bought on margin, you would lose more than 100% of your money.
Is 1 100 leverage risky? ›
Although 100:1 leverage may seem extremely risky, the risk is significantly less when you consider that currency prices usually change by less than 1% during intraday trading (trading within one day). 6 If currencies fluctuated as much as equities, brokers would not be able to provide as much leverage.
What is 1 100 leverage for $500? ›
1:100 means that for every $1 in the trader's account, a trader can place a trade worth up to $100. 1:500 means that for every $1 in the trader's account, a trader can place a trade worth up to $500.
How much is 100x leverage? ›
The Difference Between Leveraged And Non-Leveraged Trading
| Leverage ratio | Margin requirement | Buying power |
|---|
| 5:1 (5x) | $1,000 | $5,000 |
| 10:1 (10x) | $1,000 | $10,000 |
| 20:1 (20x) | $1,000 | $20,000 |
| 100:1 (100x) | $1,000 | $100,000 |
1 more rowMar 30, 2023
Using leverage is another technique that professional investors may use to provide greater potential for profit. It can also result in greater losses, although typically not more than you put in. In essence, leveraging allows you to use borrowed money to invest a greater amount and therefore amplify your results.
Do day traders use leverage? ›
Day trading often involves sophisticated products, and day traders often use leveraged investment strategies. Leveraged investing involves using borrowed capital to purchase stocks or other securities. Some examples of leveraged investing include sophisticated products, such as options trading, and margin trading.
How do I calculate my leverage? ›
To calculate this ratio, find the company's earnings before interest and taxes (EBIT), then divide by the interest expense of long-term debts.
Usually in Forex Market 1:100 leverage level is the most optimal leverage for trading. For example, if $1000 is invested and the leverage is equal to 1:100, the total amount available for trading will equal to $100.000.
How much leverage on 10x? ›
If you use 10x leverage, your position will be multiplied by ten. So if you have a 5% increase, the result will be multiplied by ten (the leverage), which means you will have 50% profit instead of the 5% you had without leverage.
Do you need leverage to get rich? ›
Leverage is the principle that separates those who successfully attain wealth from those who don't. It's just that simple. If you aren't using leverage then you are working harder than you should to earn less than you deserve — and that isn't going to make you wealthy.
What happens if you lose 100x leverage? ›
Margin trading using 100x leverage has both advantages and risks. If the trade is successful, you can gain profits equal to the increased portion size. However, if it is unsuccessful, the trader can lose the initial investment.
How much of my portfolio should be leveraged? ›
A 50% initial maintenance margin requirement results in a maximum initial leverage ratio of 2 to 1, or $2 of assets for every $1 of equity. Of course, an investor that consistently uses the maximum margin available faces an increased risk of a margin call in a market decline.
How long can you hold a leveraged trade? ›
Leveraged tokens are a basket of perpetual futures, which are essentially contract positions without an expiration date. This means that traders can purchase a leveraged token and hold their positions for as long as they wish.
Can you get liquidated on 3X leverage? ›
If it has losses on a given day, it will sell off some of its positions to reduce its leverage back to 3X to avoid liquidation. In extremely volatile situations, the leveraged token can also rebalance itself intraday. For example, it usually requires a 33% adverse move to liquidate a 3X token.
What is the major disadvantage of leverage? ›
The most significant disadvantage of leverage is that there is a risk that a company will use too much leverage, which can lead to problems for the company because there will be no benefit to taking leverage beyond an optimum level of leverage.
What is the best leverage for a $10000 account? ›
Therefore, with a $10,000 account and a 3% maximum risk per trade, you should leverage only up to 30 mini lots even though you may have the ability to trade more.
What is too much leverage? ›
A company is said to be overleveraged when it has too much debt, impeding its ability to make principal and interest payments and to cover operating expenses. Being overleveraged typically leads to a downward financial spiral resulting in the need to borrow more.
There are three proportions of leverage that are financial leverage, operating leverage, and combined leverage. The financial leverage assesses the impact of interest costs, while the operating leverage estimates the impact of fixed cost.
Can you make a lot of money with leverage? ›
Potential for higher returns
The amplified buying power provided by leverage can result in potentially higher returns compared to trading without leverage. By controlling a larger position, you have the opportunity to earn more significant profits from relatively smaller market movements.
What leverage is good for $20? ›
Traders with a $20 account should use a maximum leverage of 1:50 and should only use it when they have a good understanding of the risks involved. They should also consider the size of their trades, use a stop-loss order, and focus on building their trading skills and experience.
How many lots can I trade with $100? ›
Fortunately, any viable trading plan can be traded with a $100 account since most brokers will let you trade in micro units or 0.01 lots.
What is the best leverage for a $50 account? ›
The best leverage for $50 is 1:100 for traders outside of the EU. If you are not a resident of the EU then the leverage restrictions are very relaxed. They can go as high as 1:3000 leverage in some financial jurisdictions. The best leverage a $50 account can open in forex will depend on the broker you choose.
Why leverage is not good? ›
Using leverage can result in much higher downside risk, sometimes resulting in losses greater than your initial capital investment. On top of that, brokers and contract traders will charge fees, premiums, and margin rates. Even if you lose on your trade, you'll still be on the hook for extra charges.
