What is leverage?

What does leverage mean in trading?

Leverage in trading enables you to open a position worth much more than the money you deposit. For example, you might be able to multiply your position size by 5, 10, 20 or even 33x the amount of your initial outlay.

When trading, you’re speculating on the price movements of markets and underlying assets, rather than owning these assets outright, in the hope of making a profit. When you do this with leverage, it means that most of the capital is put up by your broker, with you putting down a deposit worth a fraction of the trade size in order to open a larger position.

Trading on stocks with leverage means you can gain exposure to a position without having to commit the full cost at the outset. The funds required to open a position – depending on the leverage ratio – represent only a fraction of its total size. There won’t be a charge for how much leverage you use – whether 5x or 20x your deposit amount.

While leverage enables you to spread your capital further, it is important to keep in mind that your profit or loss will still be calculated on the full size of your position. That means both profits and losses can be magnified compared to your outlay, and that losses can exceed deposits. For this reason, it is important to pay attention to the leverage ratio and make sure that you are trading within your means.

So, for example, you may open a trade on Tesla stock worth $1000, with a deposit of $200. Your broker would put up the other $800 initially, enabling you to open a position 5x greater than your initial outlay.

How does leverage work?

Leverage works by using a deposit, known as margin, to provide you with increased exposure to an underlying asset.

Essentially, you’re gaining exposure to a position while putting down a fraction of the full value of your trade. Although you’re only paying a small percentage of the full trade’s value upfront, your total profit or loss will be calculated on the full position size, not your margin amount.

Your total exposure compared to your margin is known as the leverage ratio.

Leveraged trading: an example

Let’s say you want to buy 1000 shares of a company at a share price of 100 cents. To open a conventional trade with a stockbroker, you’d be required to pay 1000 x 100 cents for an exposure of $1000 (not including any commission or other charges).

However, with leverage, you can pay a fraction of this cost upfront. If the margin amount was 20%, you’d pay just $200 to open a position worth $1000. Both your profits and losses would, however, be calculated on the full $1000.

If you went long on your trade and the company’s share price goes up by 40 cents, your 1000 shares are now worth 140 cents each. If you close your position, then you’d have made a $400 profit – double your initial margin amount of $200.

The reverse would be true if you went long and the share price dropped by 40 cents, you’d have made a $400 loss – double your initial amount paid. So, there’s substantial risk of losses outweighing your margin amount.

How unleveraged trades work:

When opening unleveraged positions, such as with share trading, you’ll need to commit the full value of your position upfront. For example, let’s say you want to buy 10 shares of a company at a share price of 100 cents each. To open a conventional unleveraged trade, you’d be required to pay the full $1000 upfront.

This means more initial capital outlay, but it also caps your risk. That’s because, unlike leveraged trades, the risk of loss with unleveraged trading is equal to the amount paid to open the position.

So, if you paid $1000 to open the position, the potential for loss is also limited to the $1000 you paid for the position (excluding fees and charges). However, if the market moves in your favour, your profits can appreciate as much as the share price does.

What leveraged products can you trade?

Most leveraged trading uses derivative products, meaning you trade an instrument that takes its value from the price of the underlying asset, rather than owning the asset itself.

There are lots of ways to trade these leveraged products with us. Though they work in different ways, all have the potential to increase profit as well as loss. These include:

• Spot trading: open cash positions on the spot
• Futures: open longer-term contracts for a future date
• Options: buy contracts that give you the right, but not the obligation, to buy or sell an asset on a future date

Which markets can you trade using leverage?

Some of the markets you can trade using leverage are:

• Shares
  With us, you can trade or invest in over 13,000 international and Australian-listed shares, from blue chips like Apple and Facebook, to penny stocks
• Forex
  The world’s most-traded financial market – we offer over 80 currency pairs, from major to minor and even exotic pairs, 24 hours a day​
• Indices
  We offer over 80 indices around the world, with spreads from just 1 point
• Commodities
  Trade 27 major commodities markets – including gold, oil, silver, natural gas and sugar – at their current market price with no fixed expiries
• ETFs
  We offer over 3400 ETF markets for you to gain broad exposure to speculate on indices, industries, sectors, currencies, commodities or baskets of stocks with one position

What is leverage ratio?

Leverage ratio is a measurement of your trade’s total exposure compared to its margin requirement. Your leverage ratio will vary, depending on the market you’re trading, who you are trading it with, and the size of your position.

Using the example from earlier, a 20% margin would provide the same exposure as a $1000 investment with just $200 margin. This gives a leverage ratio of 5:1.

Often the more volatile or less liquid an underlying market, the lower the leverage on offer in order to protect your position from rapid price movements. On the other hand, extremely liquid markets, such as forex, can have particularly high leverage ratios.

Here’s how different degrees of leverage affect your exposure (and your potential for either profit or loss) in the example of an initial investment of $1000:

When researching leveraged trading providers, you might come across higher leverage ratios – but be aware, using excessive leverage can have a negative impact on your positions.

Benefits and risks of using leverage

• Magnified profits. You only have to put down a fraction of the value of your trade to receive the same profit as in a conventional trade. As profits are calculated using the full value of your position, margins can multiply your returns on successful trades – but also your losses on unsuccessful ones. See an example of magnified profit
• Magnified losses. Margins magnify losses as well as profits, and because your initial outlay is comparatively smaller than conventional trades, it is easy to forget the amount of capital you’re placing at risk. You won’t be able to lose more than the balance on your account,¹ but you should always consider your trade in terms of its full value and downside potential – and take steps to manage your risk
• Gearing opportunities. Using leverage can free up capital that can be committed to other investments. The ability to increase the amount available for investment is known as gearing
• Funding charges. When using leverage, you’re effectively being lent the money to open the full position at the cost of your deposit. If you want to keep your position open overnight you will be charged a small fee to cover the costs of doing so
• Shorting the market. Using leveraged products to speculate on market movements enables you to benefit from markets that are falling, as well as those that are rising – this is known as going short, while share trading means only making a potential profit on rising markets
• No shareholder privileges. When trading with leverage, you give up the benefit of actually taking ownership of the asset. For instance, using leveraged products can have implications on dividend payments. Instead of receiving a dividend, the amount will usually be added or subtracted to your account, depending on whether your position is long or short
• 24-hour trading. Though trading hours vary from market to market, certain markets – including key indices and forex markets – are available to trade around the clock
• Margin calls. A margin call is the term for when the equity on your account – the total capital you have deposited plus or minus any profits or losses – drops below your margin requirement. At this point, your positions become at risk of being automatically closed in order to reduce the margin requirement on your account

Remember, a crucial part of risk management includes always ensuring you have sufficient funds in your account. This is because your total profits to be paid to you or losses – to be paid by you – are calculated on your full position size, not your margin amount. If your account were to go into margin call, it is important to note that your positions become at risk of being automatically closed in order to reduce the margin requirement on your account.

Let’s look at an example. Say you fund your account with $800. If you open a ASX 200 position, which has a $500 margin, then your actual position size will be worth $10,000 (20x greater).

Even though you have $300 left in your account, any movement to your position is worth the full position size of $10,000. So, if the market moved against you by more than 2%, you would not have sufficient funds in your account to cover the losses and keep the position open.

This is why a key part of leveraged trading is having enough equity available in your account.