What is leverage

What is Leverage In Trading?

It is vitally important that leverage is fully understood before anyone undertakes trading. It has advantages and disadvantages and must be used with caution.

What is leverage in trading?

Trading with leverage simply means that you can open a much larger position than you could if you were trading without leverage. When you trade with leverage your broker effectively lends you money to allow an increased position size. The amount they lend directly relates to the ratio, so a leverage ratio of 20 to 1 means for every £1 of your money your broker would lend you £20.

Let me show you an example of trading with and without leverage. These all assume we are trading a stock “XYZ Corp” which has a current price of £10. The trading account has a balance of £1000.

Without LeverageWith Leverage (10 to 1)With Leverage (20 to 1)
Buy100 shares1000 shares2000 shares
Cost£1000£0£0
Margin£0£1000£1000
Other costs will be incurred for all 3 types

The effect can be seen immediately but lets see what happens to the account balance when the price of “XYZ Corp” changes and I close the trade.

Without LeverageWith Leverage (10 to 1)With Leverage (20 to 1)
Price rises to £11£1100£2000£3000
Price falls to £9£900£0-£1000
Other costs will be incurred for all 3 types

Depending on where you live, the broker you choose and which asset types you are trading, you will encounter different leverage ratios ranging from 2 to 1 all the way up to 200 to 1.

How much leverage should I use?

The question should really be How do I best use leverage to my advantage? The reason for this is we probably won’t get a choice how much leverage we use but we can definitely control it in other ways.

To answer this new question you need to know a lot about yourself, most of which will have been answered in your Trading Journal. These include your starting capital, what you want to trade, how many concurrent positions you want, your maximum loss per trade and the style of trader you are.

To show an example for you I will assume the following:

  • Starting capital : £3000
    • this is the recommended minimum whilst discussing Brokers
  • What i want to trade : Shares
  • Concurrent positions : 10
  • Maximum loss per trade : 3%
  • Trading style : Swing

If my maximum loss is 3% per trade and I can have 10 open trades then my maximum loss at any one time would be 30%. 30% of £3000 is £900, equivalent to £90 per trade.

Lets use our “XYZ Corp” example above again. If I wanted to buy this stock at £10 and I decided my stop loss would be at £9.50 then my account could support 180 shares. If my stop loss is hit then I will lose ((£10 – £9.50) * 180 shares). This gives us our 3% loss of £90.

What is the advantage of leverage then?

Many of you will have realised from the example above that even though the price of XYZ Corp dropped by 5% the account only made a loss of 3%. This is why leverage has advantages and disadvantages.

Lets assume that we find another 9 trading opportunities that coincidentally all have the same share price and stop loss (just for ease of an example).

If all the other 9 trading opportunities also fell 5% and triggered their stop loss then the account would make a total loss of 30%. This gives you an implied leverage ratio of 6 to 1 (30% / 5%).

If your account has 10 open positions you would consider yourself unlucky to lose all 10 simultaneously (although it is possible) and this leads us to the main benefit of leverage. It allows you to diversify your positions much more than an account that does not utilise leverage.

Using the assumptions above:

  • without leverage I could buy 150 shares in 2 companies
  • with leverage I could buy 150 shares in 12 companies

Summary

The sensible use of leverage allows a more diversified portfolio of trades as well as the potential to enhance your overall return. If used unwisely though it can be a quick way to lose a lot of money.

Using this page as a guide and in conjunction with your Trading Journal and Brokers page you should now be in a better position to choose a broker best suited to your individual trading needs.

This page is purely aimed at leverage although it should not be treated in isolation as there are many other factors a successful trader must master, including position sizing and money management, to name a few.