Leverage in Trading: Margins, Formulas and Relationship with Risk
Leverage which, as the word indicates, comes from leverage, is a concept often used in many different worlds.
It is a concept used both from the perspective of the financial markets (leverage in trading), and from the business perspective (leverage of a company) and even in the real estate world, in mortgages.
In this article we will focus on explaining leverage as a concept and clarify what is specifically for trading.
What is leverage?
In the economic-financial world, leverage is the use of borrowed funds (debt) with the expectation that the results from the use of available capital (equity) together with the available capital (debt) exceed the total investment (equity + debt) in an order of several multiples and, generally, reach a much higher value than what could be achieved if we hadn't borrowed funds.
From the perspective of financial markets, leverage trading consists in using capital borrowed by a broker together with our own capital in order to invest more money in a certain position without needing so many funds.
In one sentence: leverage trading allows the investor to open a position considerably larger than the capital he has in his trading account.
Leverage in trading itself is the ratio that comes from the quotient of the amount the investor has invested from his own money and the amount with which he actually opens the position. It is usually expressed in the "X:1" format.
Example: If you have $10 and you have leverage to buy a $100 share with $90 borrowed, the leverage would be the loan provided to me by the broker and it would be a 10:1 leverage.
Although not the same, trading on margin is fundamentally the same principle. In fact, margin is used to create leverage.
Margin is the amount of money needed as a "good faith deposit" to open a position with your broker/bank.
One of the most characteristic differences is that margin is expressed as a percentage of the deposit required and not as a ratio, like leverage in trading.
Both being the same principle, why focus on differentiating between the two?
Because a perception of the concept of margin will be crucial to understand one of the characteristics of leverage in trading that we'll approach later
How does it work?
Sometimes an investor may have as part of their investment strategy to increase their exposure with as little own investment as possible. If this is the case, the investor would then resort to leverage in trading.
This would require opening a margin trading account. The leverage is then applied in multiples (2x, 5x, 10x...), and the broker lends the investor the respective multiple of the amount he wants to apply on the capital out of his own pocket.
Leverage can be used in trading on both long and short positions and can be used in the exchange of financial instruments such as stocks, currencies, indices, commodities and even crypto currencies.
Each of these instruments has a maximum limit of the leverage multiple that can be applied to it, which limit varies depending on the regulation/supervision to which the broker where to open an account is subject.
Some examples of common regulators in the retail market are:
European Securities and Markets Authority (ESMA);
Cyprus Securities and Exchange Commission (CySec)
Financial Conduct Authority (FCA)
Securities Market Commission (CMVM)
With all the aspects mentioned, it is important to note that in addition to multiplying profits, leverage also multiplies losses. Or, in other words: the higher the leverage the greater the risk for the investor.
Formulas and explanation
Let's imagine that in our account we have $1000 and we want to buy XPTO shares, whose price per share is $1.
Example 1: Trading without leverage
With our $1000 we buy $1000 shares.
If the share price goes up 10% we can leave our position at a price per share of £1.10.
Result: 1000 x $1.10 = $1100
Profit: $1100 - $1000 = $100 (or 10%)
Example 2: Trading with leverage
With our $1000 in a margin trading account we decided to take advantage of 2:1 leverage by acquiring 2000 shares investing only $1000.
That way we would have:
Exhibition: EUR 2000
If the share price goes up 10% we could move out of our position at a price per share of $1.10. Which would give:
Result: 2000 x $1.10 = $2200
Profit: $2200 - $2000 = $200 (or 20%)
As you can see, using a leverage ratio of 2:1 we were able to turn a 10% profit into a 20% profit, doubling the amount we would get without leverage.