Table of contents:
What is trading with leverage and how does leverage work? – This is what we want to deal with on this page. In the next sections I will explain to you exactly step by step how trading with leverage works. Many online brokers offer leverage, but the wrong decisions can lead to enormous capital losses. Trading with leverage is risky, so you should read this page completely before you start.
Leverage multiplies the invested capital (margin) by a fixed factor
How does the leverage work? – Example
In the upper picture you see an order mask for opening trading positions on the financial market. I have framed the contract value and the margin in red. The size 1.00 determines the contract value, which has a value of 100.000€. The margin is 3.330€.
There is a leverage of 1.30 here. This means that the margin is multiplied by a factor of x30.
Leverage means that the broker lends you money to open larger positions. You are ready to trade a larger amount in the financial markets with a smaller margin. Leverage is preferably used with Forex, CFDs, ETFs, or even futures contracts. In Europe, the maximum leverage for the private trader is 1:30 and as a professional trader, you can use higher leverage of sometimes up to 1:500. This also depends on the CFD broker. Providers outside the EU offer a standard high leverage of 1:500.
Example leverage of european regulator:
For example, you may want to trade a share via CFD. This share has a current price of 200€ on the market. Your account balance is 50€ and the leverage is 1:5. 1:5 leverage allows you to trade a maximum of 250€ capital in the market. So it is possible to trade a share at a price of 200€. If this share drops by 5€ you will lose 5€ on your trading account and it is only 45€. With a profit of 5€ per share the trading account is 55€ high. (This is an exaggerated and extreme example)
Margin Call: The risk of trading with leverage
Trading with leverage is very risky, just like any other stock exchange trading. The motto here is: “Everything can’t have to.” Leverage is a tool for Forex & CFD trading that allows you to take a greater risk. For example, in Forex trading you absolutely need this lever, because the exchange rates fluctuate below one cent per carrying.
The trader should think about his own risk management before trading. Beginners often make the mistake of trading too large positions. This quickly ends in a margin call. If a trader’s trades result in too large a loss and the account’s collateral is used up or there is not enough capital left to cover the collateral, there is a margin call and the broker demands additional collateral (margin call). The broker will inform you in advance of a margin call or automatically stop it. Many providers also allow the margin to be overstimulated to small amounts.
The margin call obligation has been abolished in Europe for Forex and CFD trading. For futures, options, or other derivatives, this margin requirement still applies. So be careful when trading with leverage. Leverage allows you to open larger positions. This can result in a larger loss or profit. You as a trader decide yourself which position sizes you want to use.
Note: Overnight margin and margin increase
For financial product futures, there is a higher overnight margin. This is not the case with Forex and CFD. The exchanges only have certain opening hours for futures contracts (futures). A distinction is made here between the day trading margin and the overnight margin. The “Overnight Margin” is higher and is required when the exchanges are closed. The broker thus protects himself against strong market fluctuations. Markets can form gaps overnight and have a new price as the closing price at the opening. This results in profits or losses.
Depending on the market situation, the broker may also reserve the right to increase the margin on assets offered. This means that the leverage is reduced and traders have to pay more for their positions. This is what happened in 2020, for example, when there was an extreme drop in oil prices. Forex and CFD brokers reduced the leverage. Open positions are usually not affected. It is the new positions that are opened.
From our experience, the lever should be used skillfully. For example, in some markets, it is not even necessary to use leverage, and in other markets, it is absolutely necessary. Here, too, it depends on the trading method of the trader. Scalpers, for example, trade with high leverage and large positions, as they only trade small market fluctuations.
The risk should be determined before each trade. Where do I set my stop loss and limit the risk with it? This question is very important and is part of professional risk management. In general, the risk should not exceed 1 – 5% of the total portfolio to build a balanced account. The risk is always set with a stop loss and determined by position size. As mentioned above, if the positions are too large, a margin call can occur very quickly if the market runs against the trader.
The risk with too much leverage
High leverage of 1:500 is not necessarily bad or harmful. In stock market trading, the risk always lies with the executor of the trade. Too much leverage tempts many traders to “gamble” on the markets. Positions of considerable size can be opened quickly. Many beginners trade without the knowledge and with too much risk. The losses can be considerable and the account quickly goes towards zero! From our experience, we can say that high leverage tempts the beginner to “gamble”. One a trader is out for a very quick profit. In conclusion, however, one must say here: It is always up to the trader himself.
Swap: Fees for Forex & CFD trading with leverage:
When trading Forex and CFDs with leverage, there may be a fee called “swap”. This only applies to trade positions that remain open overnight. The broker charges a financing fee for the trading positions. The borrowed capital must be financed. The swap fee usually occurs between 11 pm – 1 am and is charged daily. Depending on the currency pair and interest rates, this swap can also be positive. This results in interesting trading strategies. Read more about CFD trading fees “here”.
Conclusion: Leverage can increase your profit/loss
The leverage is known to every Forex and CFD trader. You should now know that the leverage increases your position size and multiplies the margin (security). Depending on the broker, market, or asset, there is a different lever. You can find the exact information on your trading platform or on the broker’s website.
Leverage does not automatically increase your risk in the market, but you do so by selecting the position size and stop loss. It is a tool that gives you the chance to increase the risk yourself and trade with higher positions. Therefore you should stick to sensitive and sensible risk management. A lever can very quickly tempt the trader to “gamble”. We, therefore, recommend that you build up a suitable trading plan and strategy to avoid rash decisions.
Summary of the trading leverage:
- The amount of leverage depends on the broker, asset and market
- The lever multiplies the margin (security deposit)
- The higher the leverage, the smaller the margin (security deposit)
- If you do not have sufficient collateral for a position there is a margin call
- The lever allows you to trade larger positions