Leverage in trading: how does it work?

So, what does leverage mean? Leverage is the ratio applied to the margin amount to establish how big a trade is going to be placed. Understanding margin and leverage and the difference between the two can sometimes cause confusion. It is important to realise that margin is the amount of capital that is required to open a trade. Learn more about margin accounts.

A leverage of 10:1 means that to open and maintain a position, the necessary margin required is one tenth of the transaction size. So, a trader would require £1,000 to enter a trade for £10,000. The margin amount refers to the percentage of the overall cost of the trade that is required to open the position. So, if a trader wanted to make a £10,000 trade on a financial asset that had a leverage of 10:1, the margin requirement would be £1,000.

Leverage can sound like a very appealing aspect of trading, as winnings can be immensely multiplied. But leverage is a double-edged sword – it is important to remember that losses can also be multiplied just as easily.

It is important for all traders to bear in mind the risks involved in leveraged trading. Many traders see their margin wiped out incredibly quickly because of a leverage that is too high. Novice traders should be especially careful when practising margin trading. It is best to be more prudent and use a lower leverage. A lower leverage means that traders are less likely to wipe out all of their capital if they make mistakes.

For example, let’s say a trader has a maximum leverage of 5:1 and opens a position on Apple shares​ with that leverage on a $10,000 account. The trader now has a position size with an asset value of $50,000, which has given them trading exposure to 5 times as many shares when compared with if they had purchased the assets outright without leveraging their starting capital of $10,000. To maintain this leveraged position in Apple stock, the value of the trader’s account would need to stay above the maintenance margin requirement of 50%, or 5,000 in this example. Read more about margin calls.

Leveraged products are derivative instruments that are worth more on the market than the deposit that was initially placed by an investor. The two significant leveraged products that we offer are spread betting​ and contracts for difference (CFDs​). When trading with leverage on either of these products, an investor can place a bet using a reasonably small margin on which way their chosen market will move. The investor technically does not own the underlying asset, but their profits or losses will correlate with the performance of the market.

The key difference between spread betting and CFD trading​ is that the former is exempt from capital gains tax (CGT), while the latter requires you to pay this tax*. CFD traders will also have to pay a commission charge in addition to the spread when trading shares. To calculate your profits or losses, you must find the difference between the price at which you entered and the price at which you exited. For spread betting, this figure should then be multiplied by the stake, and for CFDs, it should be multiplied by the number of CFD units. Both are at risk of financial loss, but equally, financial gain if the market moves in a favourable direction. Spread betting is only available to customers residing in the UK or Ireland, whereas CFDs can be used globally. Read more about our CFD commission rates​ here, along with our article on CFD meaning​.

An important aspect in using leverage is understanding how to calculate the ratio. The following leverage ratio formula is commonly used and easy to remember:

L = A / E

where L is leverage, E is the margin amount (equity) and A is the asset amount.

Therefore, dividing the asset amount by the margin amount gives the ratio of leverage.

It is also possible to start with the margin amount and apply a leverage ratio to determine the position size. In this instance, the formula would be A = E.L. Therefore, multiplying the margin amount by the leverage ratio will give the asset size of a trader’s position.

Most traders distribute risks across different markets, meaning they are not putting all their capital into one trade. This is done by opening various positions in different markets. When this is the case, there may be the need to do calculations to determine net asset value or the accumulative value of a trader’s positions. Thanks to platform technology that most brokers will offer, it is easier to monitor all parameters and open or close individual positions as needed. More importantly, it can help a trader work out if positions fit within their total leverage amounts, which should be less than the maximum leverage allowed by the broker.

Spread betting is the most popular product on our platform, which you can use to trade an endless array of financial assets. As discussed, you must use leverage when spread betting our products, which can bring risks. This is why we offer you the chance to familiarise yourself with the platform on our demo account before depositing real funds. Below, we explore the risks of spread betting leverage in more detail.

A popular risk-management tool to be considered when trading with leverage is a stop loss. By implementing a stop-loss order​ to your position, you can limit your losses if your chosen market moves in an unfavourable direction. For example, a trader may choose a pre-determined figure that they do not want to surpass, meaning that your stake in the instrument will be sold at the given price. However, please note that basic stop losses are susceptible to market gapping and slippage. Guaranteed stop losses work exactly in the same way as basic stop orders, although investors can choose to pay a small fee to guarantee the closing of a trade at the exact price specified. This way, if you have used a particularly high leverage in the trade, there will be less chance of multiplying your losses, regardless of market volatility.

Read more about how to protect your money in trading with our risk management​ guide.