What is leverage in trading?

Where leverage comes from

• Stocks on margin: your broker lends you part of the money. In the United States, the minimum initial margin to buy stocks is 50%, which works out to leverage of up to 2:1 for positions held overnight; some brokers allow more within the day.
• Futures: you post a deposit that is a small fraction of the contract’s total value.
• Options: with a relatively small premium you control a contract that usually represents 100 shares.
• Forex and CFDs (contracts for difference): these usually offer the highest leverage. Limits depend on the regulator: in the European Union, for example, retail clients are capped at 30:1 on major currency pairs.

Same move, different result

Example: you have $2,000. Without leverage, you buy $2,000 of a stock. With 5:1 leverage, you control $10,000.

• If the price rises 4%: without leverage you make $80 (4% of your capital); at 5:1 you make $400 (20%).
• If the price falls 4%: you lose $80 or $400.
• If the price falls 20%: without leverage you lose $400; at 5:1 you lose $2,000, that is, all of your capital.

In practice, your broker will usually close the position before it gets that far, with a margin call.

Leverage also speeds up drawdown. After losing 50% of your capital, you need a 100% gain just to get back to where you started.

When you can lose more than you put in

With leverage, a sharp move can push your account into a negative balance: for example, an opening gap in futures or in a short sale. In that case you owe the difference to your broker. Some regulators require negative balance protection for retail clients on certain products, such as CFDs in the European Union, but it doesn’t apply to everything. Check your account terms before you trade.

This mostly happens when price moves faster than the broker can close the position, as in a gap at the open or after unexpected news.

How to think about leverage

What matters isn’t how much leverage your broker offers, but your effective leverage: the total value of your positions divided by your capital. The broker’s figure is a ceiling, not a target.

The risk on each trade is set by the distance to your stop loss and by your position size. Leverage only determines how much capital you need to open it. If a method loses money without leverage, it loses it faster with leverage.

Example: with $10,000 in capital and $25,000 in open positions, your effective leverage is 2.5:1, even if your broker allows 4:1. A 4% move against all your positions equals a $1,000 loss, or 10% of your account.