Today, we’ll dive into a fundamental and often misunderstood concept in the trading world: leverage. Leverage allows you to trade with much more capital than you actually own, which can result in significantly larger profits if the market moves in your favor.
However, it’s important to understand that this same feature also means that losses can be equally magnified, potentially even exceeding your initial investment if not managed properly. It’s a powerful tool, but one that requires very careful risk management.
That’s why, if you have any doubts about leverage in trading, in this article we’ll try to explain as clearly as possible the questions you may have had at some point.
What is leverage in trading?
Very simply, leverage in trading is like borrowing capital to increase the size of an investment position beyond what your own capital would allow. A broker, an individual or institution that facilitates transactions between a buyer and a seller, lends you a portion of the funds needed to open a trade, in exchange for you depositing a smaller amount, known as margin.
In other words, it means being able to trade with more money than you actually have in your broker account. Beware, though—while leverage allows you to multiply your profits, it also increases losses if a position moves against you.
How does leverage work in trading?
We’ve already seen that leverage allows traders to operate with larger volumes than they own. Therefore, they can access markets that are often otherwise inaccessible.
A multiplier is typically used to express leverage, showing how many times the size of an open position compares to the trader’s actual funds used in that position.
For example, if a trader wants to execute a trade with a leverage ratio of 1:10, it means they only need 1% to open a position. With an initial deposit of $1,000, they can gain exposure equivalent to $10,000.
- 1:10 (one to ten).Means that for every $1 of your capital, the broker allows you to control $10 in the market.
- 1:100 (one to one hundred).For every $1 of your capital, the broker allows you to control $100 in the market. With $1,000, you could control a position of $100,000.
- 1:500 (one to five hundred).For every $1 in your account, you can move $500 in the market.
In reality, for each position and instrument we open, our broker will specify a required margin as a percentage. Therefore, the margin can be considered a form of collateral for the short-term loan our broker provides along with the instrument itself. That is, it’s the minimum amount we must maintain to keep trading.
Certainly, the margin is the collateral you deposit to cover potential losses in a leveraged trade. It’s a portion of your capital that is locked while the trade is open.
To better understand, let’s look at it this way: you want to open a position of $100,000, and your account leverage is 1:100. Therefore, your broker requires $1,000 from your account as margin. Suppose this position gains 1%. That means you’ll have made $1,000, i.e., 100% of your total invested capital.
Very importantly, if the market moves against you and your losses reach a certain level, the broker may ask you to add more funds—a margin call—or automatically close your position to prevent your losses from exceeding your initial margin.
Types of leverage in the markets
When seeking financing to invest, we can do so in different ways. Broadly speaking, there are several types of leverage:
Leverage in Forex
The word “Forex” is short for “Foreign Exchange”, and it’s the international market where global currencies are traded. Here, you’ll see how much the US dollar is worth against the euro or the fluctuating value of the Japanese yen against the British pound, among many other currencies. What truly distinguishes Forex is its accessibility and flexibility. We could say that leverage in Forex is:
- A mechanism that allows traders to execute trades with a volume several times greater than the actual amount of money available in their account.
- A margin trading instrument, where borrowed funds are used to increase the size of your position and, in this way, multiply your profits if capital is insufficient.
- The maximum Forex leverage is specified in the trading conditions for each account type. For example, the maximum leverage for one account is 1:200, and for another, it’s 1:1000.
Leverage in Cryptocurrencies
Also known as margin trading. It provides greater purchasing power and exposure to the trader through borrowed capital. Leveraging allows the trader to multiply the size of their positions and generate greater potential profits.
Leverage in Stocks
Like other types of securities, it’s possible to profit from price changes in stocks, both on exchanges and over-the-counter markets.
Differences between regulated markets and decentralized platforms
The financial industry is evolving rapidly, and two terms often heard today are CeFi and DeFi. CeFi is an acronym for “Centralized Finance”. This type of financing, which serves as the foundation of the global financial system, is usually managed by a central authority. Blockchain technology has given rise to a new financial sector known as Decentralized Finance (DeFi), which is not governed by a single entity.
That is, the main difference between regulated markets and decentralized platforms lies in the presence or absence of centralized intermediaries and oversight by authorities. Below are their distinctive features:
- Offers leverage through centralized intermediaries, such as banks and exchanges.
- Offers leverage through Blockchain technology to enable peer-to-peer transactions directly, without intermediaries.
Practical example of a leveraged trade
Next, let’s look at an example of how leverage works in a real Forex trade:
- Suppose you want to trade EUR/USDand have $1,000 in your account.
- You’ll use a leverage ratio of 1:50, so your $1,000can control a position of $50,000.
- If the EUR/USDexchange rate moves 1% in your favor, you’ll make a $500
- However, if the exchange rate moves 1%against you, you’ll have lost $500.
Trading with leverage vs. without leverage
The choice between trading with or without leverage depends on several factors, including the trader’s risk tolerance, available capital, and strategy. The minimum deposit is a vital factor influencing trading conditions and accessibility. Regardless of the approach, it’s essential to understand the risks and manage capital effectively.
Advantages of leverage in trading
We already know what leverage in trading is. But what does it mean for a trader? Next, we’ll present the main advantages of this type of investment.
- Multiplication of profit potential.Allowing investors to access more capital. This can be particularly useful in low-movement markets.
- Lower initial investment.Enables traders to diversify their portfolio without tying up a large amount of capital in a single investment.
- Access to otherwise unreachable market opportunities.Leverage gives investors the possibility of acquiring high-priced financial assets they otherwise couldn’t afford.
Risks of leverage: what you should keep in mind
While greater exposure can be profitable, it can also backfire and multiply losses:
- Proportional amplification of losses.Leverage increases profits but also losses. A small adverse move can quickly wreak havoc on your account.
- Risk of automatic liquidation.The risk of a margin call increases with leverage, and if you fail to meet it, your positions may be closed, causing significant losses.
- Psychological factors: overconfidence, greed.The pressure of working with leveraged positions can be exhausting. It’s crucial to maintain discipline and follow a good trading strategy.
Indeed, while leverage allows for amplified gains, it also multiplies losses. A small adverse market move can quickly wipe out an investor’s account, especially if they use very high leverage and lack proper risk management. Below is an example:
On September 2, 1998, John Meriwether, Chairman of LTCM (Long-Term Capital Management), sent a letter to his investors stating that the fund had lost $2.5 billion that year. In short, due to its extreme leverage, even small market moves in the wrong direction resulted in exponential losses. The fall of LTCM was so rapid and massive that it threatened the stability of the global financial system.
Best practices and risk management
- Use of stop-loss.Used to automatically close a position if the market moves against the trade. When trading cryptocurrencies, it’s advisable to place a stop-loss at the nearest local low to avoid further loss, severe drawdowns, and liquidations.
- Use of take-profit.A pending order that helps automatically take profits when the chart crosses the target level. It’s especially useful for beginners, who may struggle to predict the variable price range needed to reach the target value.
- To avoid problems, calculate your losses before opening each leveraged trade.The leverage ratio you use should match your risk profile.
- Never trade with money you can’t afford to lose.
- Evaluate the asset’s volatility.If you don’t protect your capital, you’ll never succeed as a Forex trader. However, you must maintain discipline, avoid excessive leverage, and, above all, never trade more than you can afford to lose.
Conclusion: when to use leverage?
It’s especially important to use a margin trading platform for cryptocurrencies that provides risk management tools. Whether you prefer spot trading or leveraged cryptocurrency trading, you should take the choice of platform seriously.
However, while potential profits increase, so do risks proportionally. The reckless use of high leverage has repeatedly led novice traders to blow up their entire trading accounts.
That’s why it’s important to always use this tool with caution, opening a larger position only if you feel confident, as the leverage effect is the most powerful weapon a trader has if used wisely. This is even more true with cryptocurrencies, because the volatility of digital asset markets already creates higher risks of losses.
To conclude, leverage is crucial for anyone interested in trading. Although it’s a very useful tool, it also carries risks if not used prudently.
Or, as stated by the National Securities Market Commission (CNMV): “Prudence and education are essential when trading with leverage. Investors must understand the inherent risks before committing their capital, as oversight seeks to protect, but the final responsibility lies in each individual’s informed decision.”
