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.
What Is Leverage in Trading?
Leverage involves using borrowed capital in order to facilitate an investment, resulting in the potential returns being magnified.
Forex and CFD leverage allows both retail and professional traders to access larger position sizes with a smaller initial deposit. Essentially, traders are borrowing money from their broker in order to increase their buying power when placing trades.
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 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 position 30 times the size of their margin. The knock-on effect of this will be that any profit or losses will also be subject to the same multiplication of 30.
How Does Leverage Work in Forex Trading?
Now we have a basic understanding of what leverage is in trading, however, in order to show how it works, 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 leverage has on our trader’s potential returns of his long position compared with an unleveraged position of the same size.
GBPUSD Increases 5%
GBPUSD Decreases 5%
Source: Table created by author
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.
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 associated with using 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 (formerly Admiral Markets) 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
By now it should come as little surprise that the greatest benefit of using leverage 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. However, it also has the potential to magnify losses caused by any adverse market movements.
For this reason, leverage must be used with great respect and caution as it has the potential to produce disastrous effects on a trader’s finances. This is why it is very important for all traders to practice good risk management when trading the financial markets.
An additional benefit of trading leverage is that it allows traders to free up their capital and use it for other investment or trading purposes.
What Is the Maximum CFD Leverage?
In 2018, the European Securities and Market Authority (ESMA), in the EU, and the Financial Conduct Authority (FCA), in the UK, placed a restriction on the maximum CFD leverage available to retail traders.
Both authorities have limited CFD leverage for retail traders to between 1:30 and 1:2 depending on asset class.
The limits on leverage are higher for those classed as professional traders, with Admirals offering their professional clients leverage of up to 1:500.
In order to learn more about the differences between retail and professional clients, you can look at the ‘Retail and Professional Terms’ section of our website.
You should now understand the meaning of leverage in trading and also how leverage works in Forex and CFD trading.
If there is one key message to take away from this article, it is that you must be careful when trading with leverage. 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.
Trade on a Risk-Free Demo Trading Account
For those who are new to trading, a risk-free demo trading account is the perfect place to practice trading using 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:
Admirals is a multi-award winning, globally regulated Forex and CFD broker, offering trading on over 8,000 financial instruments via the world's most popular trading platforms: MetaTrader 4 and MetaTrader 5. Start trading today!
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.