What Is Leverage in Trading?
When it comes to Forex and CFD trading, leverage is one of the most important concepts for new traders to understand. If you are a beginner trader and are looking for an answer to the question 'what is leverage in trading?' - you have come to the right place.
In this article, we will closely examine what Forex trading leverage is, how it works, its advantages and disadvantages and much more.
Table of Contents
What Is Leverage in Trading?
Leverage involves using borrowed capital in order to facilitate an investment, resulting in the potential returns being magnified.
CFD and Forex leverage allows traders to access larger position sizes with a smaller initial deposit. Essentially, when trading with leverage, traders are borrowing money from their broker in order to increase their buying power.
Once a leveraged trading position is closed, the money borrowed is returned to the broker and the trader either receives the profit or is liable for the loss.
In order to access and maintain a leveraged trading position, the trader is required to put down a fraction of their trade’s value as a deposit. This deposit is known as the margin.
Trading leverage is usually expressed as a ratio, which demonstrates how large a position you can open compared to the margin.
For example, a trading account with leverage of 1:30 means that a trader can open a leveraged position 30 times the size of their margin. The knock-on effect of this will be that any profit or losses from such a trade would also be subject to the same multiplication of 30.
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How Does Leverage Trading Work?
Now we have a basic understanding of what leverage is in trading, however, in order to show how leverage works in Forex, it is best to look at an example.
Let’s say that a trader who has access to leverage of 1:20 wants to buy £100,000 of GBPUSD, or one lot.
In order to calculate the margin required to open a position, one must divide the total value of the position by the leverage factor. Therefore, in the above example, the required margin is £5,000 (i.e. 100,000 / 20).
Our trader has put down a deposit of £5,000 in order to gain exposure to a position worth £100,000. The table below demonstrates the effect this leveraged trade has on the potential returns of our trader’s long position compared with an unleveraged position of the same size.
|Leveraged Trade||Unleveraged Trade|
GBPUSD Increases 5%
|+ £5,000||+ £250|
GBPUSD Decreases 5%
|- £5,000||- £250|
As can be seen, the effect of leverage is to magnify the trader’s potential returns by the leverage factor, this can be very rewarding when the market moves in the anticipated direction.
However, it can also be very costly when the market moves against the trader, demonstrating how important it is to treat leverage with caution.
Why Do Brokers Offer Leverage?
Now that you understand what leverage is and how it works, you may be wondering why brokers offer their customers the opportunity to trade with it.
Brokers earn their money through trading fees and, simply put, the larger the trading position, the more fees that they earn. This is not only true for trading commissions (if applicable), but also for the spread - which is one of the main sources of income for an online broker.
So are commissions and spreads the only cost incurred when trading with leverage?
No. Leveraged positions are also liable to an interest charge known as the swap if they are left open overnight. These fees differ depending on the asset which you are trading and the broker which you are using. The time of day at which the swap fee is incurred also differs from broker to broker.
Information on the swap fees charged by Admirals can be found in the Contract Specification section of our website or can be calculated using our Trading Calculator (which can also be used to help in calculating your Forex leverage and margin).
The Advantages and Disadvantages of Leverage in Forex
By now it should come as little surprise that the greatest benefit of leverage in trading can also be its greatest downfall.
Forex leverage offers the opportunity for a trader to magnify their potential profit when the market moves in their favour, whilst also allowing traders to free up capital to use for other trading or investing purposes.
However, as well as magnifying potential profits, trading with leverage also has the potential to magnify losses caused by any adverse market movements.
For this reason, trading leverage must be used with great respect and caution as it has the potential to have disastrous effects on a trader’s finances. This is why it is very important to have a sound risk management strategy in place when trading the financial markets.
You should now understand the meaning of leverage in trading and also how leveraged trading works.
If there is one key message to take away from this article, it is that you must be careful when trading with leverage. Forex and CFD leverage can be an incredibly useful tool to traders when used correctly, however, it also has the potential to cause heavy losses if not used with caution.
Therefore, it is important for traders to use Forex leverage in conjunction with a proper risk management plan.
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For those who are new to trading, a risk-free demo trading account is the perfect place to practice trading with leverage. A demo trading account from Admirals allows you to trade with virtual currency in real-market conditions! Click the banner below to open an account today:
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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.