When we talk about Forex and CFD trading, leverage is one of the most important concepts. If you are a beginner trader and you are looking for the answer to the question “what is leverage in trading?”, you have come to the right place.
In this article, we will take a detailed look at what leverage is, how it works, what its advantages and disadvantages are, and much more.
What is leverage in trading?
What is leverage in simple words?
Leverage is the use of a broker's borrowed capital to increase the potential return on an investment.
Leverage ( or leverage ) in Forex allows both retail and professional traders to trade high volume positions with a small initial deposit. Essentially, traders borrow money from their broker to increase their purchasing power when placing trades.
As soon as the trading position opened by the trader using leverage is closed, the borrowed money is returned to the broker, and the trader, depending on the success of the trade, either makes a profit or incurs losses.
In order to be able to open and maintain a position with leverage, a trader must deposit a portion of the value of such a trade in the form of a deposit. Such a deposit is known as margin .
Trading leverage is usually expressed as a ratio , which indicates how many times the amount of your margin you can open a position.
For example:
a trading account with a leverage of 1:30 means that a trader can open a position up to 30 times his margin. The important thing to remember here is the leverage effect: any profit or loss will also be multiplied by 30.
How does trading with leverage work?
Now we have a general idea of what financial leverage is in trading, however, to understand how leverage works , it is best to look at an example.
Let's say a trader with a leverage of 1:20 wants to buy £100,000 worth of GBPUSD, i.e. one lot .
To calculate the margin required to open a position, you need to divide the total value of the position by the leverage ratio. Therefore, in the example above, the required margin is:
100,000 / 20 = £ 5,000
Our trader made a £5,000 deposit to open a £100,000 position. The table below shows the impact of using leverage on the potential return of a buy position compared to a position of the same size without using leverage.
| Leveraged | Without leverage | |
| Shoulder size | 1:20 | - |
| Invested funds | £5,000 | £5,000 |
| Position volume | £100,000 | £5,000 |
| GBPUSD up 5% | +£5,000 | + £250 |
| The GBPUSD pair fell by 5% | -£5,000 | - £250 |
The example above clearly shows what leverage is for: the effect of leverage is to increase the trader's potential profit by the leverage ratio, which can be very useful if the market is moving in the expected direction. However, you can also pay dearly if the market moves against you.
Many are interested in the question, is it possible to trade without leverage ? You can, while you can open transactions with volumes not exceeding the funds available on your account. However, the relatively low level of risk will be an advantage.
Why do brokers offer financial leverage?
Now that you know what leverage is and how it works, you might be wondering why brokers offer their clients the opportunity to trade with leverage.
Brokers make money from trading commissions , and, simply put, the larger the trading position, the more commissions they earn. This applies not only to trading commissions, but also to the spread , which is one of the main sources of income for an online broker.
So commissions and spreads are the only costs associated with using leverage?
No. When leveraged, positions are also subject to interest, known as swaps , if left open overnight. The swap size varies depending on the asset you are trading and the broker you are using. The time of day at which the swap is charged also varies from broker to broker.
Should you trade with leverage? Pros and cons of leverage
By now, it shouldn't surprise you that the biggest benefit of using leverage may also be its biggest downside.
Forex leverage gives a trader the opportunity to increase their potential profits , provided that the market moves in their favor. However, it can also increase losses caused by adverse market movements.
For this reason, leverage should be used with great care as the consequences for a trader's funds can be dire. This is why it is extremely important for every trader to apply a good risk management strategy when trading the financial markets.
Another advantage of trading leverage is that it allows traders to free up their capital and use it for others to make more investments or trading purposes.
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