Our partner, XM, lets you access a free demo account to apply your knowledge.
No hidden costs, no tricks.
Simply put, leverage is how much money a trader can borrow from their broker to initialize trading positions on financial markets. The way brokers give leverage to their traders is how many times the account balance traders can use to enter a trading position.
Leverage in financial trading is one of the most fundamental concepts. Without a deeper understanding of the leverage and its impact on trading results, developing a profitable strategy is impossible. Traders who do not correctly understand the leverage concept are going to blow up their trading accounts.
In financial trading, the majority of retail traders trade with leverage. It can vary between 1:2 and 1:1000 or even more depending on the broker, financial markets, and trading account selected. Usually, the Forex market has the highest leverage, sometimes reaching several thousand to one ratio.
1:100 leverage, which is very common in Forex, means the trader can open a trading position 100 times their trading balance. Considering this, leverage can be a powerful tool at a trader’s disposal when used correctly. But trading with leverage has both advantages and disadvantages and without proper knowledge, it can be very dangerous.
The standard lot size in Forex and many other financial markets is 100,000 units of currency. In the EURUSD case, 1 standard lot is 100,000 USD. In the past, traders had to trade with a minimum of 1 lot to be able to access financial markets. But, not all traders have such large sums of money to use it in the risky business of trading. This is why brokers came up with the idea to allow traders to borrow money during the opening of trading positions.
The brokers also made adjustments to lot sizes and are now allowing traders to open positions with lot sizes well below 100,000. The majority of brokers nowadays are offering minimum lot sizes from 0.01 lots and 0.1 lots, enabling traders with tiny budgets to access financial markets. Leverage allows traders to trade with a much lower budget, which is very advantageous.
The leverage can only be used on the opened trading positions and is not added to the trading account. This allows brokers to lend money to traders and limit them from withdrawing these borrowed funds.
When a trader opens a trading position using leverage, the collateral is locked away and is referred to as equity.
But what happens when a trader uses large leverage? They can lose money, so brokers have to prevent traders from losing the borrowed funds. Margin calls and stop-outs prevent traders from losing brokers’ funds by notifying them to add funds for trading. If a trader does not add funds when a margin call is received, the broker liquidates all opened trading positions to prevent the trader from losing the broker’s capital.
Margin calls and stopouts are defined as percentages, and traders should be aware of these conditions to avoid stopouts. Brokers usually display these percentages on their websites.
So, what are the benefits of using leverage in financial trading?
Despite its numerous benefits, trading with leverage bears some serious risks every trader must know.
To employ the full potential of leveraged trading and make it to your advantage, you need to calculate the leverage and use it wisely. Let’s take an example of 1:100 Forex leverage on the 100 USD trading account. The maximum trading capital will equal 100×100= 10,000 USD. But trading with this much volume can quickly drain the account, as a loss of 100 pips can blow up the account and trigger a margin call and stop out. Even a 0.1 lot size which is 10,000 could be dangerous for a 100 USD account with 1:100 leverage if the trading strategy is a long-term approach.
Now that we know what leverage is and how to use it in financial trading, we can define basic concepts to use it in trading.
Firstly, always use a trading strategy that has every single detail defined. Using well-developed trading strategies lets traders employ the full power of the leverage and make profits.
Use moderate leverage to ensure one single losing trade can not blow up a trading account. The most common way traders use leverage is not to risk more than 1-2% for every single trade. This is achieved by the proper position sizing method. When you have a large leverage, it is always useful to adjust position size to withstand losses. To risk no more than 2% on a trading account with 1:100 leverage and 1000 USD balance, trailers must not trade with a higher lot size than 0.1 lots. This way 20 pips stop loss will be just 2% of the trading account which is very healthy.
Depending on the account balance and financial goals, this can be a difficult task to achieve. The best way would be to counter how many losing trades your trading account can withstand and compare it with the winning rate of your trading strategy. For a 100 USD account, it would be better to risk no more than 5-6 USD per trade. This is higher than 2% but also more reasonable. This way you can withstand around 20 losing trades and the majority of trading strategies won’t experience that many consecutive losses. Risking no more than 5-6% per trade can help traders stay in the game of financial trading for a long time and make profits along the way.
Overleveraged is the primary cause of blowing up trading accounts. This is very easy to happen to beginners, and this is why reading this guide is very important. It is difficult to shrink the complex concept of leverage to just one tiny guide, but all the essentials are here for the reader.
Another mistake is to invest a very tiny amount of money and use large leverage. It is always preferable to match the leverage to the account balance. The higher the account balance, the lower the leverage should be. Investing 100 USD and trading with 1:1000 leverage can be a receipt for destruction. Proper lot sizing is crucial
The third common mistake made by beginners is to use improper trading lots compared to their trading account and leverage. Trading with 1 lot on a 100 USD account with 1:1000 leverage means to lose 100 USD in a single losing trade.
So, leverage is a powerful tool that allows traders to open larger trading positions with small account capital. 1:100 leverage means to open a position with 100 times the account balance, making a 100 USD account capable of opening a 10,000 USD trading position. Using leverage without a trading strategy and careful risk planning can end in a disaster, and beginners are especially susceptible to these flaws. Overleveraged trading has probably the most victims in the world.
Proper risk management is only possible after calculating the leverage properly. Make sure not to risk more than 1-2% on any single trade when using a large trading budget. For lower budgets of 100 USD, it is possible to risk 5-6%. Proper position sizing can help traders use leverage wisely and make while reducing risks of blowing up a trading account in one losing trade.