What is leverage and how does it work?

Introduction

Leverage is a term which is usually associated with the use of a form of debt which is taken on by an investor in order to invest in an asset or undertake a project which may result in financial gain or appreciation of value.

Therefore, it is important to look closely at the meaning of leverage within the electronic trading context, which is a method offered within forex and CFD trading on over-the-counter (OTC) trades in order to enable traders to open large positions with a much lower amount of money in their trading account.

In theory, the idea behind leverage is to give traders more presence in the capital markets environment and attempt to increase potential profit by having a larger amount to trade with, which is usually determined by a percentage ratio.

What is leverage in retail trading?

It is common practice among retail trading, especially with instruments that are commonly traded within the retail market, specifically Forex and CFD products in which commodities or equities are the underlying asset, a percentage of leverage is applied so that investors can increase their exposure to the market by allowing them to pay less than the full amount of the investment.

Consequently, using leverage in a stock transaction, allows a trader to take on a greater position on a CFD relating to a stock, or on the price difference of a Forex pair, without having to pay the full purchase price.

How does leverage work in retail trading?

The vast majority of Forex brokerages andCFD trading companies offer leveraged trading to all of their clients.

Usually, leverage ratios range from 1:25 to approximately 1:100.

In some circumstances, leverage ratios of over 1:100 are available, however high levels of leverage are often not permitted by most financial markets regulators, most of which have stringent guidelines regarding the percentage of leverage that a brokerage is allowed to offer to traders, which usually ranges from between 1:25 to 1:100 depending on the jurisdiction and regulatory authority.

The function of leverage in retail trading is to provide a potential balance between risk and reward in which traders can trade a larger amount in the market, because their own margin capital is being magnified by the leverage percentage when it is traded in the market.

For example, if a trader invests £3,000into a trading account to be used as margin capital with which to trade the markets, it would be magnified by 25 times if the leverage ratio is 1:25 or magnified by 50 if the leverage ratio is 1:50.

What is the risk?

With leveraged trading, there is a degree of increased risk, just as there is an increased possibility of reward. The magnification of margin capital into a higher amount in the live market also means that the magnification of potential loss is equally possible.

However, in most cases, market makers which offer leveraged trading will not allow a trader’s account to accrue a negative trading balance if the market goes against the trader to the extent that losses are magnified to the tune of the leverage ratio, which could potentially lead to a trader owing money in excess of their initial deposit to a broker.

This is because most market makers which execute trades on their own dealing desk are not processing trades through to the liquidity providers or banks, but instead executing the trades in-house which means that they can manage the risk themselves on behalf of traders and therefore the maximum losses that could be sustained by a trader would be that their account goes to a zero balance rather than a debt.

In this circumstance, the potential gain is in line with the amount of leverage that has been provided, but the potential loss is often limited to having a zero balance in the trading account.

Negative trading balances only occur when a broker passes the trades to the Tier 1 interbank forex trading market, and to external liquidity providers which then would seek to recover a leveraged loss from a trader if the market went against their trade to the extent that a loss created a negative balance.

In times of market volatility, there have been circumstances in which negative trading balances have occurred and in some cases these have been large enough to cause the actual brokerage to become insolvent as they were unable to collect the balance from their traders and had exposed themselves to magnified losses due to leveraged trading in a live market.

In the case of market makers, which the vast majority of retail brokers are, this risk is mitigated by not exposing themselves or their traders to the risks of sending leveraged trades to external liquidity providers.

The risk with market makers is more that a leveraged trade which is closed as a losing trade will likely remove margin capital at a much faster rate than an unleveraged trade, because the position in the market was magnified compared to the amount of margin capital. Therefore a small investment into a highly leveraged position could result in very quickly losing all margin capital.

On this ground, leveraged trading among market makers with ratios lower than the maximum allowed by regulatory authorities is the de facto method within the retail trading market globally.

Is leverage a debt?

In traditional physical investments such as real estate or valuable artefacts, leverage is often a debt instrument.

For example, investors in property may take mortgages in order to raise the capital to purchase real estate and then either make regular payments with interest to a lender or a lump sum on the sale of the real estate plus any interest charged by the lender in the view that the real estate will increase in value to the extent that a profit can be taken after the loan and interest is repaid.

In the financial markets, leverage is often not regarded as a debt and does not carry the characteristics of a debt.

This is because there is no lending of money directly to a trader via a consumer credit agreement in order to place trades. The trader deposits margin capital into a trading account and then the brokerage places leverage onto that capital when it is traded in the market.

In a market-making scenario, should loss-making trades be executed, the trader will not owe the brokerage any money.

Thus, it is not a debt in the traditional sense, and does not come with the same responsibility of repayment.

Summary

Leveraged trading is now the de facto method of trading the global capital markets throughout the entire over-the-counter (OTC) trading industry. Over recent years, regulatory authorities around the world have begun to limit the amount of leverage that broker ages are allowed to offer to their customers, however it is an intrinsic component in trading and therefore widely accepted as a means of gaining higher ‘skin in the game’ for a lower amount of investment capital than would otherwise be possible.

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